When the market is swinging all over the place, it’s only natural for investors to sit on the sidelines. And it seems like the smart thing to do, right?
Investors equate volatility with risk. The more volatile a market is, the higher the chance they believe they will lose their money. It’s this fear of losing money that keeps them out of the market.
And it’s not as if the fear is unfounded. In a volatile market, an investor could buy in to a stock just as the bottom falls out of the share price. They can then end up chasing the share price down as they try to scramble out of their position. As other investors panic, the share price gets sold down further as everyone rushes for the door.
It’s a situation that everybody wants to avoid. But as much as investors fear volatility, how do you measure it?
It’s right there in front of you
You can gauge the volatility of a stock by looking at its price chart. Volatility measures the size of the swings in the share price against an average price.
By plotting a line of these average prices over a period of time — called a simple moving average — it smooths out the day-to-day fluctuations to give a clearer view of what the stock is doing. This moving average gives you a base against which you can compare the stock’s daily swings.
But you don’t need to get too carried away with plotting lines and calculating sets of data. What you want to look out for, apart from the stock’s direction, is whether volatility is rising or falling. That is, bigger or smaller swings against the moving average.
We’ve all heard variations of the old saying that markets rise by climbing the stairs and fall via the elevator shaft. Because prices typically fall harder and quicker than when they rise, volatility tends to increase more in falling markets, and reduce in rising markets.
Buying into a rising market with volatility on the wane appeals to all investors. Who doesn’t want that? It’s this kind of market that brings investors in from the sidelines.
But as appealing as it sounds, buying in periods of low volatility isn’t as safe as you think.
Markets are not rational
Markets tend to overshoot in both directions. As markets climb ever higher, volatility can fall lower and lower. But markets always correct — that’s what they do.
Because of this, big downward corrections in the market can often be preceded by periods of excessively low volatility. While all investors enjoy a rising market (along with lower volatility), they also need to ensure that it’s not leading them into a false sense of security.
In itself, volatility isn’t enough of an indicator to use to initiate a position in the market. But some traders actively look for periods of below-average volatility as a potential trigger to go short in a stock. That’s because, by definition, a market must return to its average at some point in the future.
The obvious (and hard) part is knowing when this will occur. But even if you’re not an active trader looking to short the market, you can still use volatility as a gauge before you look to add to an existing position.
It works both ways
Just as periods of excess-low volatility can preface a fall in the market, the opposite can also be true. Periods of above-average, or excess, volatility can also indicate the market has been sold off too far.
A spike in volatility reflects the panic, as everyone tramples on each other to get out of a stock. After getting out, this is the type of market where many investors will park their cash and sit on the sidelines.
But these events can be short-lived. It can also be the type of market that can throw up some really good opportunities.
As with the low volatility scenario, periods where the market remains highly volatile — above its long-term average — will at some point return to its average. Again, this is what markets do — they correct themselves.
This can coincide with a market bottom leading to a potential correction to the upside. Often, the bounce can be strong, as investors pounce on bargains.
That being said, we still need to keep to our stop-loss levels in case we get it wrong. The bounce could be a correction before the market sells off again. But rather than fearing volatility, it can be seen as an opportunity to scout for stocks trading below their value.
For Markets and Money