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THE HIGHER THE VOLATILITY THE HIGHER THE RISK…

But the greater the opportunity

by Mike Lally

If you fail to minimise risk you are going to self-destruct by gradually bankrupting your account. There are numerous forms of risk, some of which you can’t control.

Many risks are random and unpredictable, like the weather, terrorism, sporting contests, and my latest hair style. Even when the risks are unpredictable you can often see them coming.

We are concerned about avoidable and unavoidable risk. Any number of strategies such as diversification can reduce avoidable risk. Unavoidable risk is the trader’s worst nightmare.

The good news is that unavoidable risk can be broken into two separate components:
Controllable and Uncontrollable.

Controllable risk can be factored into your trading plan by using a protective stop.
There is nothing you can do about unavoidable and uncontrollable risk apart from totally withdrawing your funds from the market.

An instrument whose return is unpredictable and varies from period to period is volatile and will carry significant risk. It’s pointless focusing only on the downside risk as you will never make a trade.

We do not want to eliminate all risk from our share portfolio because we want to generate a healthy profit. If a trade has a higher number of possible outcomes it will share its potential with a higher volatility reading. We want to manage the risk in order to avoid too much loss.

A variation in risk will occur if the stock returns within your portfolio do not move precisely together over time. What makes price move? Largely it is driven by supply and demand.

It is a function of market and sector risk. It would be true to say something like 80% of time spent by the average trader is focused on stock selection. Yet only 20% of risk is caused by the stock itself.

If 80% of the risk is based on market and sector considerations why spend too much time pondering the likely movement of a given stock?

This is where fundamental analysis comes unstuck. If you spend 80% of your time investigating the ins-and-outs of companies you are still covering only 20% of the risk.

Selecting stocks solely through fundamental analysis can be a flawed approach since it is not concerned with how a sector is performing and this is where the majority of the risk lies.

Use of fundamental analysis to select stocks is useful but it should be complemented by technical analysis to decide when to buy.

TWO FORMS OF RISK

There are many forms of risk but two types of risk variability we can examine are: Unsystematic or Risk belonging to a company and Systematic or Market-related risk.

You clearly have some control over the first type of risk but not the second.
Diversification as explained can work for and against you.

Since you can sell a stock at any time you need to assess what can be done about overall market risk.

Can it be measured?
Market and individual share risk is known as volatility and it can be measured using the formula:
(12 months high – 12 months low) / 12 months low

For an individual stock the daily price range is the difference between the high of today and the low of today.

It pays to convert the calculation to a percentage figure given it is more pragmatic to talk in terms of percentage moves rather than specific price moves.

To do this, multiply the numerator by 100. The greater the result the higher the volatility, the greater the opportunity and the riskier the market or trade.

You can subject a share to a comparison with the market as a whole to determine its volatility.

This is known as market breadth and can be achieved using this formula:
Price advancing stocks – Price declining stocks / Total stocks

The higher the volatility the greater the risk but also the greater the opportunity. Volatility is the price you pay to get higher returns. It is difficult to make money when the volatility is low.

If the price doesn’t move you can’t make a profit. The market can change polarity quickly. You can be trading under low volatility one minute and high volatility the next. The news plays an important part in this sea of change.

You must recognise that it takes the market longer to alter its volatility from high to low than to change from low to high. It’s all to do with the level of excitement. A security with a high range of volatility will rise and fall to a greater degree than a security with low volatility.

THE CLOCK IS TICKING

Volatility is a key measure since it reveals how the market is trading today relative to the past. Volatility in the markets has been at levels not seen since 1998.

If you have an indication of the range of volatility over a known time period you can estimate whether the current setting is reasonable, sustainable or dangerous – hence it can be used to estimate future volatility.

If an investor is uncertain of the timeframe he is trading he is liable to lose money in spite of sensibly applying technical analysis tools. Timing is everything.

Once you have determined your trading objective based upon your analysis you run the gauntlet of volatility risk if you do not fully appraise timing intricacies.

Market and share volatility can vary from day to day. The volatility of a stock needs to be understood by the trader. Volatility is unpredictable as it is constantly changing. Its relationship with risk is often misunderstood.

The extrapolation of volatility is a handy means of quantifying the associated risk. One of the dangers of using volatility to encapsulate risk is the tendency to assume all risk is bad.

Volatility is not always bad since without it we can’t make money; however we tend to instinctively think of risk as something that will cause loss.

Irrespective of past data you can never assume volatility will be constant – it rarely is, though its recent history can be used as a benchmark.

If the anticipated stock movement is unexpected there are any number of potential negative outcomes which may cause you to lose money.

The trend you are hoping to trade may take a longer time to materialise or it may be much shorter and catch you napping. Either way you have failed to match your target price objective to the expected move because of a timeframe mismatch.

In one scenario you may believe the share should increase in price at the end of a week’s trading. However, ten days later the anticipated move may not have materialised.

The trader is often unaware that volatility has altered to a lower figure and consequently the price move has stalled. Many people begin to panic and withdraw from the market.

Without warning volatility alters again and the expected move happens, unfortunately too late for the trader.

Volatility can increase as well as decrease. Here the trader stays in the trade too long, he sees the expected move take place quite quickly and he dreams there is more profit to be made; alas the volatility alters again and he is forced to give back most of his profit.

As each trade is filled it pays to establish a base target. Unless you use a stop-loss mechanism you will pretty soon discover that volatility is your nemesis and retribution is close by.

If you negotiate the target price by systematically identifying market and share volatility you will benefit because the market itself can dynamically set it.

If the overall market or any one stock is too volatile or too flat perhaps you should postpone trading until you feel more comfortable and the conditions are more in sync with your trading style.

This power is within you! Future volatility is the key measure all traders wish they knew. If you know the future volatility you instinctively know the right odds.

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