At the heart of all trading and investment strategies are methods for dealing with volatility. Volatility is inevitable, but it's impossible to know whether it's a warning sign of a shift in the primary trend of a stock or whether it's just random and meaningless.
Volatility can shake you out of good positions, but it can also offer great opportunities to add to your favorite stocks.
Volatility Comes Into Play in Two WaysFirst, it helps in determining the right places to set stops. If you underestimate routine volatility, you will be constantly stopped even though there is no real change in conditions. If you overestimate volatility, then you will suffer bigger losses when there is an actual change in the trend of a stock.
The second way volatility comes into play is that it provides good short-term trading opportunities. Upside volatility offers the potential for a quick flip and a remount at a lower price. Downside volatility can offer a good opportunity to ramp up position size in a favored name.
The first step in dealing with volatility is to develop some sense of what is a normal level. This is very difficult to do because it depends not only on the particular stock but on overall market conditions. Normal levels of volatility will expand and contract all the time.
How to Measure Volatility
One way to measure volatility is to look at how much a stock moves compared to a benchmark like the S&P 500. A stock with the same volatility level as the S&P would have a beta of 1, but a stock like Tesla (TSLA) moves much faster in both directions. Currently, the beta of Tesla is about 2.1 using monthly data for the last five years. That means we can expect Tesla to move roughly double the movement in the S&P 500.
Knowing a stock's beta can be quite helpful in setting stops at levels so that you aren't shaken out by routine volatility. They can be found on Yahoo Finance and many other places.
Aggressive traders tend to favor stocks with higher levels of volatility simply because they are likely to produce much better returns if you pick the right ones. Of course, that also means that there is potential for bigger losses if you are in the wrong name.
Navigating volatility in small-caps or high-beta stocks is an art form. If you play it wrong, it will destroy a good trade, but if you handle it correctly, it can enhance your returns.
My approach to dealing with stocks with high levels of volatility is to use an incremental trading approach. I want to buy and add to positions on downside volatility and then sell into upside volatility. The tricky part is that if volatility does not reverse after you make your move, you have to reevaluate your strategy and decide whether to take a loss if a drop continues or chase positive momentum if a stock keeps racing higher. I deal with that by maintaining positions with different time frames and different stops and buy levels.
One mistake that many traders often make is that they are always looking for an explanation for why a stock may be moving. Quite often, there is no fundamental reason. It may just be market conditions or sellers making moves that have nothing to do with the merits of a stock.
The best move you can make is to consider volatility before entering a trade. Quite often, a stock will immediately move against you for no good reason. If you plan on that in advance, volatility will be your friend rather than your enemy.