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!