Today'sTrading Lesson From TradingMarkets

Volatility

Measuring the volatility of stock can get complex. However, you don’t have to understand the formulas inside and out to benefit from them. Quite simply, volatility is how much prices fluctuate over time. If you understand this, you know enough about volatility to apply the concepts discussed in this article.

Historical Volatility

Historical Volatility (sometimes referred to as statistical volatility) is the standard deviation of day-to-day price change expressed as an annual percentage. With everything constant, and assuming a normal distribution, a stock trading at $100 with an HV of 10% has a two-thirds chance of trading between $90 ($100 less 10%) and $110 ($100 + 10%), a year from now.

Obviously, everything does not remain “constant” and stock prices don’t fit perfectly into a statistical “normal distribution,” but you get the picture. The higher the HV number, the more the stock has fluctuated in the past and the more likely the stock will continue to fluctuate, going forward.

If you find the concept of HV confusing, you don’t necessarily have to use it when looking for volatile stocks. A simple “eyeballing” of the chart will often do. For instance, if a stock goes from $10 to $100 over a short period of time, then drops to $70, and then skyrockets to $200, that stock is volatile. The reason I use HV (versus simply "eyeballing" charts) is twofold, first it provides a standardized measurement to which all stocks can be compared and second, it lends itself well to computer-based scans.

Trading Where The Action Is

In Connors on Advanced Trading, Larry Connors showed that the stocks with the highest HV readings offered the most opportunity. He stated:

"...trading in sideways markets will chew you up…As short-term traders, we do not have the luxury of waiting for a market to move. Because our profits tend to be small, we need to be trading those specific markets that provide us with the opportunity to maximize our profits on a daily basis."

Connors’ research is the basis for our Trading Where The Action Is List -- a list of the 15 most volatile stocks as measured by their 50-day HV.

The Explosion In Volatility

When Connors was conducting his initial research (circa 1997), some of the highest HV stocks had readings between 40% and 60%. Stocks such as computer manufacturer Dell Computer and broker Morgan Stanley/Dean Witter made the list. Although somewhat volatile, stocks such as these now pale in comparison to current volatile stocks.

Since 1997, we have had a technology explosion in the market, based on the hyper-growth of the Internet, with offshoots into business to business companies and so forth. Biotechs once again resurfaced, with spinoffs in Genomics. Semiconductors, software and communications technology to support these -- and many other technological advances -- boomed.

In addition to the above, the incredible growth of online brokers and market-related information gave even the smallest of traders tools and means that were previously only available to the larger, more sophisticated traders.

All of the above has contributed to the massive explosion in the volatility of many stocks. Stocks with 50-day HV readings of 80%, 100% or even 200% have become fairly common.

For instance, let’s take a look at Geron (GERN), a volatile Genomic stock. This stock, which had high 50-day HV readings in January 2000, proceeded to gain 700% over the next few months. The stock then topped out and then imploded, losing over 80% in subsequent months.

Structure

Even though stocks like Geron exhibit tremendous potential to move based on high volatility readings, you obviously can’t buy or sell short stocks like this randomly, simply because the volatility is high. You need some sort of pattern or setup that suggests the likely direction. I refer to this as "structure." Structure, helps suggest (but does not guarantee, of course) the likely direction of the stock. Herein lies the opportunity: Combining structure with volatility.

Structure can be defined as momentum, bigger-picture patterns and setups.

Momentum

Momentum can be in the form of strongly trending stocks as measured by ADX, RS or simply "eyeballing" the chart. Visual signs of momentum include new highs, gaps, laps and wide-range days (in the direction of the trend, of course).

Classical Patterns

Classical Patterns may include pullbacks, cup and handles, double bottoms, bases, retracements and many other technical techniques.

Setups

Setups can be short-term patterns such as Trend Knockouts (TKOs), three- to eight-bar pullbacks (or defined pullbacks such as Connors/Cooper’s 1234), 180s etc. Setups can also include "micro" versions of bigger-picture patterns, such as a high-level “mini” cup-and-handle or a short-term double bottom, a short term narrow base (eg., the Slim Jim) and so on and so forth.

Note: Most of these setups are covered in the TradingMarkets.com Guide To Conquering The Markets. Also, Jeff Cooper, Kevin Haggerty and I often give examples of these and other setups in our daily commentary.

Putting the Pieces Together

The more “pieces” that fit together, the better. For instance, a highly volatile stock in a strong uptrend that forms a “mini” cup and handle combined with setups such as a three-bar pullback from highs or a Cooper “180” and/or a Trend Knock Out (TKO) has a high likelihood of success.

Examples

The best way to explain structure and show the potential of volatile stocks is through examples. Below I will walk you through the analysis on several charts.

Above we showed that highly volatile stocks such as Geron had the potential to make tremendous moves. In this case, approximately 700% up, followed by a 80% drop. However, we also stated that random buying or shorting without structure would be a recipe for disaster. So let's look at some structure the stock exhibited on the way up and during its subsequent collapse.

It began to show momentum at (a) as evidenced by new highs (b), gaps at (c), (d), new highs at (e). Additional structure included a micro cup and handle at (f), a wide-range day higher and new highs at (g), new highs at (h), and a breakout from pullback at (i).

On the downside, it had a head-and-shoulders top, failed pullback, and 180 sell setup at (j). At (k) it had a wide range down, followed by a three-bar pullback at (l). Continued down momentum at (m) followed by a Trend Knock Out at (n).

Taking a look at Affymetrix (AFFX) another highly volatile stock as measured by HV. Notice the strong momentum followed by a cup and handle which also had new highs and a three-bar pullback as part of its handle.

Taking at look at Alexion Pharmaceuticals (ALXN), the stock had high HV (greater than 70%) at (a) and even higher HV at (b). The stock breaks out of a base at (c) then rallies to new highs at (d), then after a shallow pullback (e), rallies once again to new highs at (f). It pulls back once more and finds support near the last pullback/base (g). It then rallies to new highs and breaks out of a consolidation at (h) followed by yet another shallow pullback and explosive move higher at (i).

The Catch?

Above I have shown that combining volatile stocks with structure can create tremendous trading opportunities. Almost too good to be true. So what's the catch? The catch is that you will be increasing you risk considerably when trading stocks that fit this criteria. Therefore, money management becomes crucial.

The simplest way to reduce risks while still allowing yourself to capture significant gains is to reduce your position size. In addition, you might consider hedging positions with options and in some cases possible outright option purchases.

As you can see, provided you exercise strict risk control, combining volatility with structure can be highly profitable.

Going Forward

In order to implement the above concepts I strongly urge you to learn as much as you can about structure, volatility and most importantly, money management and position management. I have included a list of resources. Obviously, there's no substitute for experience when it comes to trading volatile stocks, but studying the materials listed below is a good start.

Volatility
Connors on Advanced Trading: Larry Connors, M. Gordon Publishing
Option Volatility and Pricing Strategies: Sheldon Natenberg
Introduction to Volatility, Volatility in Action, Historical Volatility: Dave Landry.
A Volatility Trade In Gold: Dave Landry, Technical Analysis of Stocks and Commodities, July 1998 issue.

Structure/Setups
Connors on Advanced Trading: Larry Connors, M. Gordon Publishing
Hit and Run Trading I: Jeff Cooper, M Gordon Publishing
Trading With Cup-And-Handle Patterns, Trading Pullbacks: Dave Landry
Mark Boucher's 10 Week Short Term Trading Course: Mark Boucher.

Money Management
The Hedge Fund Edge: Mark Boucher.

Money Management-Four Part Series, Position Management-Two Part Series, Dave Landry

All of the Above
The TradingMarkets.com Guide To Conquering The Markets: various contributors.
Connors On Advanced Trading: Larry Connors.
The Hedge Fund Edge: Mark Boucher.