This Weekend’s Trading Lesson From TradingMarkets

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

By Greg Che

Editor’s
Note:

Brice

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).

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)
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!