Volatility is measured using the standard deviation in price change of a stock’s price against its price at any given time, or measured as the variance of the change of the stock price against a benchmark, for example a market index. A commonly quoted measure of volatility is a stock’s beta. This simply tells the investor the correlation of the stock to its benchmark index (typically the S&P 500 Index). A stock with a beta of 1.3 has historically moved 130% for every 100% of the Index move. So a stock with a high beta will deviate from the index mean more than a stock with a low beta.
What all this means in layman’s terms is that the volatility of a stock is the amount a stock is likely to move away from the price at which it was traded at any given time.
Higher volatility means that the share price range is likely to be wider than the range for a low volatility stock. From an investor’s viewpoint this is an important concept. Stock’s that move by larger margins can be more profitable on the upside, but also carry a greater risk of loss. In other words, volatility is a measure of risk.
What does this mean for the day trader?
For the day trader volatility is a two edged sword. If a trading range can be identified, then the higher the volatility means the greater the spread between levels of support and levels of resistance. And this means the greater the opportunity to make profits: if the spread between low and high points is 10%, then a buy and sell round trip transaction will offer a wider margin than a stock that trades with an upper and lower price differential of, say, 2%.
Now consider the costs of trading. Whether you are charged on a percentage basis, or in cents per share, the impact of trading fees will be less for a more volatile stock. Take the example above, and let’s say the share price is $1, and the cost of trading is 1 cent per share. Where the stock moves by 10%, the impact of the cost of buying stock at $1 and selling at £1.10 cuts the profit to a net $0.08. Trading costs 20% of the gross margin. Were the trader to buy and sell shares at the lower and upper limits of the less volatile stock, then his profit of $0.02 would be completely wiped out by his trading costs.
So, volatility doesn’t only impact upon gross profitability, but can make a huge difference to net profits.
Something else that a trader has to be wary of is that the downside of a stock with higher volatility is larger than one with a lower volatility. Placing a stop loss at 2% down in a stock that often moves by 8% or 10% will mean that the trader has a greater chance of seeing the stop loss executed, writing in many small losses. So a trader must be willing to accept a larger downside if his trade turns sour, to stop unnecessary smaller losses mounting up.
Trading in volatile stocks can be very profitable
Because some volatility is so important to trading profitably, day traders are unlikely to select stocks that only move in a range of a couple of pennies. A trader needs the possibility of margin, even if trading profits aren’t guaranteed. It is his skill and strategy that will build his profits, but no amount of trading ability can make net profits in a stock where trading costs are larger than the trading turn.
For this reason, some traders actively seek out the most volatile stocks in which to trade. This can be a long and taxing process, though fortunately there are websites that provide such information. One of these is marketvolume.com, which also allows the input of price ranges and share trading volume for a customized list to suit the individual.
A trader needs volatility, but must also be aware of its magnitude. The volatility of a stock will play a key part in stock selection for trading, and will impact on the effect of brokerage costs on trading profits. Stop loss strategies will need to be considered carefully to avoid unnecessary and unacceptable losses, yet at the same time protect the trader from the inherent downside risk of volatile stocks.
Finally, it has been shown through stock trading history that volatility increases in markets that are trading downward. Therefore while the potential upside of buying volatile stocks is apparent, the downside may be even greater because the stock is trading in a downtrend. This is one of the major reasons that stocks with higher volatility tend to have a lower share price, on the US stock market often below $5.