What Historical Volatility Means To You On A Daily Basis
Each evening we give you the names of the most volatile stocks in our “Trading Where the Action Is†section. We also give you the volatility rankings of all commodities in our Futures section. Tonight and next Tuesday, May 11, I will explain to you what the rankings mean and how to apply them to your trading.
As I wrote in an earlier article, it is difficult to make money in markets that have small daily ranges because the spread, slippage and commission (“the takeâ€) on a percentage basis of your likely move is too large. That’s why you need to be in markets that have large daily ranges to help minimize these inherent costs.
Let’s look at what you can likely expect on a daily basis using volatility as your guide. For example, Wednesday night, pork bellies had a 50-day historical reading of 41%. This means (assuming volatility remains the same) that bellies have a 2/3 chance of closing within 41% above or below today’s price, one year from now. Let’s assume that bellies are at $.60. Historical Volatility tells us that there is a 67% chance that prices will be between $.36 and $.84 a year from now.
As short-term traders, we obviously want to know where prices will be over the next few days, not a year from now. Let’s use the very volatile stock Knight/Trimark (NITE) and ask where it will likely close five days from today. Let’s assume its price is $150.00 and its volatility is 153%. The formula is:
- Step 1: Take 260 trading days and divide it by 5 trading days, which equals 52.
- Step 2: Take the square root of Step 1 and you get 7.2.
- Step 3: Divide the stock’s current volatility of 153% by Step 2 = 21.25.
- Step 4: Add 21.25 to the stock’s current price and you get 171 *.
Subtract 21.25 from the stock’s current price and you get 128 *.
This now tells us that if volatility remains basically unchanged over the next five days, the stock has a two out of three chance of closing between 128 * and 171 *.
In Tuesday’s column I will show you how to apply this information to your day-to-day trading.
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