Today’s Trading Lesson From TradingMarkets

In general, volatile stocks have the
potential to make the largest moves. However, you can’t just randomly buy or
sell short a stock just because it is volatile. You have to have some sort of
combination of momentum, pattern or setup — what I refer to as “structure.”
In this Trading Lesson, I will review
how to measure volatility and, more importantly, how to combine it with
structure to help capture explosive moves.

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

A Volatility Trade In Gold: Dave Landry, Technical Analysis of Stocks and
Commodities, July 1998 issue.

Structure/Setups

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.

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