Are you using these indicators to measure stock price volatility?
When choosing a security for investment, it’s important to look at the company’s past stock price volatility to help determine the relative risk of a potential trade.
There are a number of metrics you can use to measure volatility, and each trader has his or her favorites. If you have a fundamental understanding of the concept of volatility and how it is chosen is crucial to having success investing.
In simple terms, volatility is a reflection of the degree in which price moves. A stock price that fluctuates wildly is considered to be volatile. An equity that is able to maintain stable price levels has low volatility.
Stocks with higher volatility are riskier than those with lower volatility. When someone invests in a volatility security, the likelihood for success is increased, as much is the chance of failure.
Because of this, a lot of traders with a high-risk tolerance choose multiple indicators to determine volatility, which helps with their trade strategies.
Some of the most common volatility measures include Beta, Maximum drawdown, and standard deviation.
Beta
Beta measures a security’s volatility relative to the broader market. A beta of 1 indicates that the security has volatility that mimics the direction, and degree of the broad market.
For example, if the S&P 500 takes a deep dive, the stock in question is likely to mirror that direction by a comparable amount.
Equities that are relatively stable, such as defensive stocks or utilities, have a beta of less than 1, reflecting it’s lower levels of volatility. On the other hand, sectors like technology that is constantly changing at fast pace have a beta measure of more than 1.
If the security has a beta of 0, that means that the underlying security has no-market related volatility. Cash is a great example if no inflation is considered.
Though, there are low and sometimes negative beta assets that have relatively high volatility that has no direct correlation with the stock market. Long-term government bonds and gold are great examples of such assets.
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Maximum Drawdown
Maximum drawdown is an indicator that traders use to measure a security’s volatility. The maximum drawdown associates with the biggest historical loss for an asset. Its’ measured from peak to trough within a given time period.
It is also possible to use options to ensure that an investment will not lose more than a fixed amount. Investors may choose asset allocations with the highest historical return for a certain maximum drawdown.
Using this indicator derives from the idea that not all volatility is bad for traders. It’s common for most investors to want big gains, but in doing so they also increase the standard deviation of an investment.
It’s important to understand there are ways to achieve large gains while simultaneously minimizing drawdowns.
Growth investors search for stocks that go up more than the market in an uptrend but remain stable during a downtrend.
The concept behind it is that these equities remain steady because investors hold onto winners, despite minor pullbacks. That shows potential winners and lets the growth investor buy a stock where the volatility is mainly on the upside initially.
Eventually the stock will see bigger losses during downtrends. Speculative traders use this as a signal to look for new winners or will transition to cash position ahead of a bear market.
Standard Deviation
The main measure of volatility used by investors and traders is the standard deviation. This metric mirrors the average amount a stock’s price has changed from the average over a period of time.
Calculating the average price for the established time period and then subtracting that number from each price point determine it. The difference squared, summed and averaged to determine the variance.
Due to the fact that the variance is the product of squares, it’s no longer the original metric to measure. Price is measured in dollars, a metric that uses dollars squared is difficult to evaluate.
One can calculate the standard deviation by using the square root of the variance, which will return it to the same unit of measure as the underlying data set.
Technical analysts use an indicator called Bollinger Bands to measure standard deviation for a period of time. Bollinger Bands consist of three lines; Simple moving average (SMA) and two bands, which one is above and below the SMA.
The SMA is a way to look at the stock price’s history, though it’s slower to react to changes. The outer bands reflect those changes to show the corresponding adjustments to the standard deviation.
The standard deviation displays with the width of the Bollinger Bands. The wider the Bollinger Bands means the more volatility a stock’s price within a specific time frame. A equity with low volatility has a more narrow Bollinger Bands that rest near the SMA.
