As we approach the end of the 2020 calendar year, if there is one thing as traders, we have learned to deal with, it is volatility in the marketplace. Just in this year alone, we have experienced the most significant market crash and fastest rally in history. It is almost like volatility demanded its place at the stock trading table at this year’s holiday gatherings. So, let’s take a few moments and cover what volatility brings to the stock trading table.
Volatility is defined as a range of price changes in a stock or index over a given period. If the price of a stock stays stable, volatility is considered to be low. If a stock’s price sees new highs and lows that quickly or erratically fluctuate, then volatility is considered to be high. There are two main types of market volatility: historical volatility and implied volatility.
Historical volatility is defined as a statistical measurement of the fluctuating price movement in an underlying security over a given period. It is relayed as an annualized percentage and basically estimates how far a stock’s price can move away from its mean or average value at any given time. It should be noted, the higher a stock’s historical volatility is, the riskier the stock is considered to be when it comes to investing or trading.
Historical volatility measures past changes or fluctuation in the price of a stock, and implied volatility represents the expected price fluctuations of a security or index. Because it is implied, we are unable to use past performance and an indicator of future performance, but we can use it to forecast the possible movement of a stock’s price. Granted, forecasting is far from an exact science; however, implied volatility can provide a window into a stock’s likely behavior.
Actually, it is both. Volatility can be a positive or a negative, depending on the circumstances and your perspective. High volatility can scare people away from trading because they feel like they are unable to predict whether a trade will be a win or a loss. But volatility can also create opportunities for educated and prepared traders; by taking advantage of the opportunities, a trader can quickly and efficiently get into and out of profitable trades. The key here is using good analysis to navigate the upcoming market and paying close attention to the indicators outlined above.
One of my favorite indicators to use when it comes to tracking volatility is Bollinger Bands, which I covered in my Foundations of Stocks and Options blog here. In short, when you are looking at Bollinger Bands on your candlestick chart, widening of the bands indicates increased volatility, and narrowing of the bands implies decreased volatility. The chart below shows both ATR and Bollinger Band on GOOG and is an excellent graphical representation of marketplace volatility.
In closing, I have learned from recently completing the entire Foundations of Stocks and Options class that having the right mindset is vitally important when it comes to trading, especially day trading. It requires discipline, constant learning, and a certain level of volatility tolerance. The Foundations class provided an excellent rock to stand on when it comes to starting my trading journey, but there is still room for growth. And to that end, check back each Thursday during the 2021 calendar year as I present coverage on various classes from Tradesmart, which will are designed to lead traders like you and me on the next level of our trading journey.