What's Tomorrow's Range? Find Out Using Historical Volatility

Volatility research was popularized by Larry Connors, CEO of TradingMarkets and author of three excellent trading books, Investment Secrets of a Hedge Fund Manager, Street Smarts (co-authored with Linda Raschke), and Connors on Advanced Trading Strategies.

In Investment Secrets of a Hedge Fund Manager (which Connors co-authored with Blake Hayward), the authors wrote: “We predict that the use of historical volatility will be one of the growth areas for research in the financial markets in the late '90s” Boy, were they right. Volatility research has indeed become one of the most important tools for any trader, whether in options, stocks or futures. It is a tool used by all traders in all time frames.

In this article, I would like to introduce the use of Historical Volatility as a determinant for daily and weekly price movements. Using volatility in determining how much a stock will move is a key component to deciding what stocks you will day trade or swing trade. The reason: Volatility is a key underlying factor that determines how much a stock will move in a given period of time.

I won’t bore you with the formula for historical volatility as most charting packages (SuperCharts, TradeStation, TC2000, etc.) provide you with this indicator. However, a brief description of historical volatility is: the standard deviation of the logarithmic price changes of the underlying.

As a day- or swing trader, you would most likely be interested in finding out what the day-to-day volatility is of the underlying you are trading. Naturally, you would like to find the stock or commodity with a nice price range. You can create an indicator in your charting package to do this. In the chart below, I have inserted both the 50-day historical volatility and the daily price movement based on volatility for IDEC Pharmaceuticals (IDEC | Quote | Chart | News | PowerRating).

As you can see by the chart, historical volatility is around 72% and the daily price range of the stock is almost 2 points. This would be an ideal candidate to trade, if you were looking for a high-volatility stock with a decent daily price range.

Looking at a low-priced stock in the same industry, Amylin Pharmaceuticals (AMLN | Quote | Chart | News | PowerRating) has a high 50-day historical volatility reading in the 80s. However, price movement is miniscule in the eyes of a day- or swing trader.

On an intermediate-term basis, the same applies. Taking a look at the weekly price movement of IDEC, you can see that the stock typically moves approximately 4 points a week. This information is helpful in that you can determine how you would want to trade (i.e., intraday, swing or day trade) and how you could place your stop.

This is one of the simplest methods to using volatility in your trading in locating stocks with price ranges which one can day- or swing trade. My brother trades arbitrage positions and utilizes volatility to determine whether the arb is feasible and worth putting on.

Using volatility to determine how much price will move allows traders to determine if a stock should be traded or not. As many of you are aware, volatility is mean reverting so, by applying this principle with low volatility situations, conceptually you can focus on those stocks that can give you the most bang for you buck!