Stock Volatility Explained - Financhill

Stock Volatility Explained

Stock Volatility Explained: There is a science to investing in the stock market. Collecting and analyzing financial and economic data can lead to smart trading decisions. However, when it comes to buying and selling securities, science will only get you so far. To date, there is no formula that delivers perfect results with every trade. 

The most successful investors focus on the science of the market first, then take creative liberties. They understand that investing is as much an art as a science, and they find a balance between risk versus reward, known versus unknown, and historical fact versus future predictions to create an investment strategy that meets their goals. 

Stock volatility is a critical factor in both the science and the art of successful trading.

Historical volatility data shows patterns in the market’s response to events impacting a particular stock, and implied volatility (IV) gives a glimpse into what might happen in the future.

Investors who can harness the power of this data to time trades just right often find there are substantial rewards for their efforts. 

What is Stock Volatility?

So, what does stock volatility mean? At its most basic, stock volatility is the extent to which share prices increase and decrease. It measures how fast those movements are, how often they occur, and how big they are.

For example, a stock that consistently increases by around five percent after every quarterly earnings report has low volatility, while a stock that is up 20 percent one week based on earnings reports, then down 30 percent based on rumors of regulatory changes has high volatility. 

There are several measures of volatility that can be helpful in attempting to predict a specific security’s future movements: 

Historical Volatility (HV)

As the name implies, historical volatility is a look back at a stock’s volatility in the preceding 12-month period.

High levels of volatility correspond to higher risk. For some investors, that can mean higher reward. 

Implied Volatility (IV) 

Implied Volatility is a forward-looking measure that projects how volatile a given stock is expected to be in the coming 30-day period.

The score is calculated based on data compiled from options being traded in the open market. When the prices of futures options increase, it follows that volatility will increase as well. 

Market Volatility (MV)

It’s worth noting that market volatility can provide important information for investors making trading decisions. This figure is a measure of how quickly prices are changing in a given market – for example, the stock market or the commodities market. 

One frequently-referenced measure is the Chicago Board Options Exchange’s Volatility Index, otherwise known as the VIX. This figure looks at the implied volatility of the S&P 500 over the next 30 days, based on the same data around pricing of options contracts.

The VIX is also known as the “fear index”, because it is essentially a measure of how investors are feeling. Higher volatility indicates greater uncertainty among investors, and an upswing in the VIX often indicates a coming drop in stock prices. 

Buying stocks with high volatility is inherently more risky than buying those with low volatility, because the value of your investment could drop at any time, for any one of a dozen reasons.

Of course, higher risk tends to come with higher rewards. Companies with particularly volatile stock prices know they need to deliver value if they want to attract investors, so their goal is to drive rapid growth and expansion – and therefore higher earnings. If that’s not an option, they tend to pay higher-than-average dividends to make the risk worthwhile. 

What Causes Stock Volatility?

There are a variety of factors that tend to drive volatility, though it is fair to say that debate on which factors are associated with a significant impact is quite heated.

As a general rule, share prices tend to move up or down dramatically when there is an imbalance in trading activity – for example, many more buyers than sellers, or vice versa.

When demand is high, share prices go up, and when demand is low, share prices go down. Changes in demand typically result from some change in the status or health of the underlying company. 

The types of changes that drive a sudden, dramatic imbalance of supply and demand – and therefore an increase in volatility – include unexpectedly positive or negative results from scheduled earnings reports, news about the company’s leadership, products, or other internal factors, changes in the regulatory environment, and in some cases, geopolitical events.

For example, an announcement of deteriorating relationships with an important trade partner can impact stocks across an entire industry. 

Some industry experts disagree that volatility is directly related to these types of events. They assert that the imbalance in supply and demand results from an uptick in activity from short sellers, institutional investors, and day traders.

In other words, these experts believe that large trades from this type of investing activity can impact share prices by shifting the balance between supply and demand. 

Yet another theory suggests that volatility is heavily influenced by investor emotion. While other theories assume the market self-corrects based on all available information, this theory suggests that no such logic is at work.

Instead, it suggests that a company might catch the attention of investors for some reason, resulting in a collective response to buy or sell shares. As prices change to meet demand, more investors follow the trend. Eventually, there is a snowball effect that causes significant volatility. 

Of course, there are companies that experience seasonal volatility, which – while predictable – is still unnerving for investors with low risk tolerance. For example, ski resorts don’t make money in the summer, and amusement parks tend to close in the winter. These scenarios are a little different for investors who base trading decisions on volatility, and they should be factored into decision-making accordingly.

Is Stock Volatility Good or Bad?

The question of whether stock volatility is good or bad doesn’t have a simple answer. Instead, it’s a matter of degree, as well as whether and how varying levels of volatility fit into your specific investment strategy.

An asset that has zero volatility would never increase in value, which presents a number of issues. Most importantly, there would be no return on the investment, and after inflation risk, investment fees, and similar, you could theoretically lose money.

On the other hand, an extremely volatile stock, like say Tesla [TSLA] is as likely to drop in value as it is to increase in value. That could result in a loss of your principal investment. 

The key is to find the right level of volatility – and the right level of risk – to meet your financial goals. Generally speaking, those with short-term financial goals are better off with a more conservative approach, as they lack the benefit of time to make up any losses.

Those with longer-term financial goals can afford to take more risk, because if they experience losses, they are more likely to recoup those losses over time. 

With that said, many investors are willing to accept more risk, and potentially higher rewards, by adding volatile stocks to their portfolios. They offset a portion of the risk by diversifying their holdings to ensure if one asset fails to produce returns, another will keep the portfolio’s overall value steady.

That’s why you might see an otherwise conservative investor purchasing shares in a risky biotech or technology startup. They have ensured that the rest of their portfolio can absorb any losses, so they accept higher risk in hopes of realizing impressive rewards if the company is ultimately successful.

How to Trade Stock Volatility

Because volatility is, to some extent, unpredictable, attempting to profit from high-volatility stocks is a high-risk strategy. However, there are some methods that have a relatively strong record of success, attracting the interest of experienced investors. 

Day traders, those that make a career out of profiting from small movements in the market, are best suited for a strategy centered around trading stock volatility.

They are constantly vigilant as conditions change, and they are in a position to capitalize on volatility real-time. Their strategy is built around holding positions for minutes or hours – a far shorter time period than average investors. 

Swing traders operate in a similar manner to day traders, but their time frame is a bit longer – perhaps days or weeks instead of minutes and hours. 

Day Trading Volatility Vs Swing Trading Volatility

Day traders and swing traders use a variety of available data to predict when shares of a given security have hit their low, then they buy.

Using the same data points, they attempt to identify when prices have peaked, and they sell. They profit from the difference in purchase price versus sales price.

Essentially, they follow the age-old “buy low/sell high” strategy, but they do it in an extremely short period of time. 

Day traders and swing traders don’t necessarily have to buy and sell actual shares to profit from short-term volatility. In many cases, they accomplish the same results by trading options contracts – both calls and puts. 

How To Trade Volatility Using Options

Calls are options contracts that give the owner the right to buy a certain number of shares of an underlying asset at a specific price. However, there is no obligation to buy.

The named price, also known as the strike price, is effective through the contract’s expiration date. As share prices  of the underlying security become more valuable, the options contract itself grows in value. 

Puts are options contracts that give the owner the right to sell a certain number of shares of an underlying asset at a specific price. Though the owner has the right to sell the shares, there is no obligation.

The strike price is effective through a specific expiration date. As the price of the underlying shares goes lower than the strike price, the contract becomes more valuable, much like buying an inverse ETF such as DXD gains in value when the Dow Jones falls.

It can then be sold with a higher premium attached, which is the fee paid to the owner for the sale.

Through buying calls and selling puts, day traders and swing traders profit by collecting enhanced premiums when the options become more valuable in relation to the underlying security.

Investors who don’t plan to trade based on volatility specifically but wish to add a volatile stock to their portfolio, should keep one best practice in mind.

When placing an order, consider a limit order versus a market order. Market orders are executed as soon as administratively possible once they are placed, but when shares are particularly volatile, it is possible that your final price could be significantly higher than you expected.

Instead, place a limit order which specifies your price threshold. If share prices exceed that threshold when your order is to be executed, the order does not go through. 

What is a Good Volatility for a Stock?

The volatility of a particular stock is known as its beta. The beta is a comparison of the stock’s volatility against the S&P 500 Index.

If the specific stock’s movement corresponds perfectly with the S&P 500 Index, it has a beta of 1.0. If the given stock has a beta greater than 1.0, it is more volatile than the S&P 500 Index. Conversely, if the beta is less than 1.0, the stock is less volatile than the S&P 500. 

As mentioned, “good” and “bad” volatility are relative terms. Your level of comfort with a specific volatility figure depends on your tolerance for risk, your trading strategy, and your financial goals.

How To Find Volatile Stocks for Day Trading

If you are ready to get started with day trading using a strategy based on volatility, the big question is how to find volatile stocks.

The first step is to define “high volatility” for your own purposes. Are you looking for stocks that tend to have big differences between daily highs and daily lows, or are you interested in stocks that have the highest trading volume? 

Perhaps you are looking at other criteria altogether, based on volatility over a given timeframe or some other combination of factors.

In nearly every case, there are tools and resources available through free and paid online services and apps that can identify volatile stocks for day trading that meet your criteria. 

Should I Invest in Volatile Penny Stocks?

One of the most important questions to consider is whether you plan to trade volatility in penny stocks. The most volatile penny stocks can offer good relative returns, though of course, the in real returns, the figure is comparatively low.

However, when pursuing penny stocks, bear in mind that you should probably place your bet on the side of a sudden decrease in value, rather than a sudden increase.

In a large number of cases, penny stocks eventually land at a value of $0. 

Most Volatile Stocks Today

If you are ready to test the waters with trading on volatility, these are some to consider:

most volatile stocks today 

Stock Volatility: The Bottom Line

The bottom line is that stock volatility is the extent to which prices change. Low volatility is associated with lower risk, but that typically means lower rewards.

High volatility means prices change frequently and dramatically in either direction. While there is more risk associated with high-volatility stocks, there is also greater potential reward. 

Day traders and swing traders often rely on a volatility-based strategy that aims to profit from movements in the prices of specific stocks.

While there are tools and resources that offer guidance in predicting when and at what price stocks will hit their valleys and peaks, no one has found a method that is always successful.

That means this strategy is best reserved for sophisticated traders who are in a financial position to manage high-risk, high-reward portfolios. 

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.

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