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TME 027: Volatility

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What is Volatility?

 Volatility defined

A statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.

INVESTOPEDIA EXPLAINS ‘VOLATILITY’
In other words, volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.

One measure of the relative volatility of a particular stock to the market is its beta. A beta approximates the overall volatility of a security’s returns against the returns of a relevant benchmark (usually the S&P 500 is used). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on price level. Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index.

 

So lets give an example of volatility. If you went to a movie and you were watching a scary movie. Lets say its Friday the 13th with Jason and his hockey mask. In that theater everyone would be on edge. Suppose as you sit in that theater a man walks in with a hockey mask on and cranks up a chainsaw. You could easily predict that the theater would become highly volatile. People would be knocking each other over to get out of that theater. There would be a high level of volatility in that theater.

 

Well the market in some ways is like that theater. The investors hear the media talk and talk and talk on the news. They blow stories out of proportion and then one day something happens and boom the market gets volatile. Volatility can also creep in or it can come in slow. Volatility can be calculated and in fact it is one of the variables in the price of options.

 How should you use volatility in trading?

Your trading system should have a way to measure volatility. It should help drive your position size. If the market has high volatility you will take less risk. If the market has low volatility then you will take more risks. A good trading system will use it to tell the trader how much to trade.

There is an index called the volatility index. It is used to calculate the volatility of the market. I suppose someone could say if that index is high I will not buy as much. If this index is low then I will buy more. A trader could do that but that would leave too much discretion to the trader.

 

Volatility for the new trader

As a new trader I risked way too much on every trade. I had good signals but I would lose too much on every trade. One reason that I lost too much is because I did not understand the value of a stop. The other is that I did not understand volatility. Volatility is very important.

Lets look at the following example:

Lets assume you buy AAPL @ 100 dollars. Lets also assume that the volatility is high. By high I mean it is moving 5% per day.

 

Lets also assume that you are only going to lose 2% on each trade.

 

Your account Value: $10,000

Stock Value:                    $100

Volatility:                               5%

Safety Stop:                          2%

 

Example 1

The max value that you will lose on a trade is what?

$10,000*2%= $200

How much should you buy?

Buy = Max Loss/Volatility = $200/5%= $4000

There are many formulas to calculate volatility this is just one example. You need to figure out what works for you.

 

Example 2

Now assume that the volatility is only 1%.

How much should you buy?

Buy = Max Loss/Volatility = $200/1%= $20,000

So in this example you would need a margin account. This is only an example of how volatility works this is not the formula that we use in our system. Our system calculates he volatility daily and makes calculations based on the formula that we put into the program.

Conclusion

Every trader needs to remember that volatility is very important in trading. It is not enough to have 10 stocks and always risk the same amount on each stock. Volatility makes it where all stocks are not equal. Volatility can make or break a trade. If you don’t calculate volatility then you will get stopped out because you are risking too much, or you will not make any money because you are not risking enough.

If you are trying to build a trading system it is very important that you calculate volatility.

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