Surely you’ve heard me say this before…
“Volatility is a trader’s best friend.”
But let that sink in for a minute, and I’ll explain to you why you should like volatility.
First, let’s establish that there are two different approaches to investing.
Investors: These are people who make investments with longer-term outlooks. They buy or sell stocks based on fundamental and technical analysis. They typically take a buy and hold approach and are happy beating the market over the long run.
Traders: These are the people who are trading with shorter-term outlooks. You could be trading for a few hours, or even minutes (day trader), all the way out to trading with an expected holding period of a month – or even two (swing traders).
Traders tend to use more specific indicators that are tuned in with the specific holding period that works best with their approach.
For the record, I fall more into the swing-trader category, with a trading window of 24 days as my most effecting range. I use the 20-, 50- and 200-day moving averages as my trinity of trendlines and also utilize the 20-day RSI. I include the use of several proprietary models that focus on breakout potential and how the options market is positioned on a stock.
There’s Also Another Big Difference Between Investors and Traders…
In general, investors dislike volatility. When the market, or a stock, gets volatile and starts to see extreme price swings, investors tend to worry. They prefer a smooth ride on a bullish trend. They like to set it and forget it, not have to read about their stock or worry about the fact that it may fall 15% in a week.
On the other hand, TRADERS LOVE VOLATILITY. As I’ve already said, “volatility is a trader’s best friend.” That’s one of my Ten Commandments of Trading, and it’s been true of traders since before I even knew what the market was.
You see, because traders are looking for a quick move to cash in on profits, they actively look for situations where a stock might enter what I call a “volatility surge,” or “volatility storm.” That’s when a stock goes from being relatively quiet to moving aggressively.
Think about this for a second…
The average return for the S&P 500 is somewhere around 10-12% a year. “Investors” are ecstatic to get a one-year return of 18%. I mean, that’s 50% more than the average. You’re going to retire early at that rate, right?
Well the average “trader” wants to find the opportunity to grab that 10-12% in a much shorter period – maybe 10-20 days. And then do it over and over, compounding their returns and making that 18% look like a gratuity. You only get that by finding volatility in the market BEFORE it happens, and then harnessing it.
Here’s How I Find Volatility BEFORE it Happens…
It’s MATH silly. If you didn’t know it, I’m a bit of a math nerd. That’s a good thing, because the stock market is just a bunch of numbers, and they all follow the rules of math. In this case, we’re talking distribution.
Just like your high-school chemistry class grades, the market follows a “Standard Distribution.” Remember, the old Bell Curve? Same thing, only you can apply that theory to price changes of the market or a stock (a.k.a. volatility).
Here’s how it works…
I use the Bollinger Bands as a measure of volatility, but I do it just a little differently. I look for the moments when the top and bottom Bollinger Band is at one of its smallest spreads over the last year. That’s not a “natural” resting place for the market, as it suggests that a stock has been unusually quiet or lacked volatility over the last month.
That’s the key… unusually quiet for the last month. It’s the calm before the storm.
These volatility squeezes indicate that the quiet stocks are about to return to their “normal” volatility, which means we will see a volatility breakout in the near-term future.
There’s one catch. Volatility is not directional by its nature. In other words, volatility can take a stock higher or lower, it just means that the stock is about to make a larger and faster move than it has been making for the last month. The direction, that is something that you need to determine.
Last week we talked about the 50-day moving average (MA50). Remember, “the trend is your friend?” This is where you apply this and other DIRECTIONAL indications to determine which way the upcoming volatility surge will drive the stock… higher or lower.
Let’s look at an example.
Here is a sample list of stocks from my current Volatility Squeeze List. There are 51 in total today.
General Motors Co (GM) currently finds itself on the list, as the stock is seeing the smallest spread in its current volatility readings. The last time GM had a volatility reading this low was December 2022, just ahead of a volatility surge that took it from $40 to $33.
This time around, GM shares are seeing the volatility squeeze come as the stock’s MA50 is in a decline, and the faster-moving 20-day moving average (MA20) is also overhead to provide resistance.
The combination of the volatility squeeze AND bearish intermediate-term technicals suggests the volatility surge will drive GM shares lower.
My approach pinpoints a level that will serve as the catalyst for the price to accelerate to the downside, and in GM’s case right now, that price is $32.
How do I use this volatility forecast?
I set my price alert at $32, and on the next break of that price, I add an at-the-money put option on GM in the July expiration cycle. My target for the stock is $30, so I use that as my closing target for the option.
There you go… turning volatility into my best friend by:
- Finding the “quiet stocks,”
- Determining the directional move that will result from the volatility, and
- Determining the price at which the volatility surge will be triggered.
I’ll have more on this approach and how you can implement it with your trading as we move forward.
May 18 2023