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 | Quote | Chart | News | PowerRating), 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 | Quote | Chart | News | PowerRating) 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 | Quote | Chart | News | PowerRating), 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.
