Does Volatility Kill?
By Lynn Carpenter
This time we will tackle volatility, which is probably even easier and much more misunderstood.
People who trade options study volatility closely. They hunt it out or avoid it. They massage it and time it. They know it can work for them, or against them, and in either case it strongly affects their price.
In contrast to the option trader, most of us stock investors give volatility very little thought, if any.
If that's you, you can continue to trundle happily down that path, ignoring the whole issue… if you stick with blue chips and plan to hold them for 20 years, that is.
Otherwise, it would be worth your while to give the subject a little notice. A great deal of what the experts tell you about stocks and how to handle them is closely linked to their beliefs about volatility and their reactions to it.
But on the more practical level, volatility may also affect whether you are profitable, what kind of stocks you should buy and how you handle your money.
As with the series on trend lines, I am going to break this subject down into rational pieces. You will find that the subject is not abstract at all, and is certainly not as complex as some people would have you think.
Normally, a discussion of volatility in stocks heads right to the deep waters of Modern Portfolio Theory, beta and academic studies. We'll get there, but we'll start at the commonsense end of the subject, before academics chop it up and give each of its parts ten-dollar names.
Refer to the attached image.
In the past year, Lockheed Martin and Overseas Shipping Group have both done well and gone up about 12%. In that time, the Dow and the S&P both lost ground. Investors who bought either one of these stocks should be happy with their gains so far.
But I will bet you that many aren't. Lockheed is a little off its peak, but most of all, it was fairly boring. Those looking for big excitement probably weren't satisfied with this nice, steady march.
Overseas Shipping would have troubled even more investors. Even if they were happy to have 12%--as any sensible person should be—the ride was a rough one. The stock was up 35%, it was down 11%, up 15%, down 13%, up 6%, down 15% and finally up 12%.
That's volatile!
In fact, both stocks have volatility, but Overseas Shipping has a lot more of it. On a practical level, spotting volatility is like recognizing good art—I don't have to define it for you. You know it when you see it.
Now, think about using stop losses. Everyone who bought Overseas Shipping when it was getting hot in April to June last year took a loss on the stock if they used a 25% trailing stop.
Everyone who bought the stock in April, most of May or the second week in June who ignored the volatility, stayed off the stop-loss crutch, and stuck around has made money. In fact, there were only 16 weeks in the past year where it was possible to buy Overseas Shipping at such a high price that you would be down today (well, as of April 22, when I made this chart). But only if you did not use trailing stop losses.
Contrast that to Lockheed Martin. A stop loss would have been a nice bit of insurance to comfort the investor who doesn't want to check every position every day. The stock had its ups and downs, but not enough to trigger a 25% trailing stop.
Is this a claim that stop losses are evil? Heck no. But I will proclaim loud and clear that half the people who use them and most of the people who advise them don't think it through. You cannot buy a stock like Overseas Shipping Group if you are not willing to let it wander. This applies to quite a few stocks, most biotechs, for instance. You are, in fact, more likely to lock in a loss than to avoid one if you put a standard trailing stop on a volatile stock.
If you want to use stop losses all the time, don't trade extremely volatile stocks. Period. The two instincts are at odds. Volatile stocks hint at big returns and excitement, not safety. Safety does not usually come on the kind of stocks that smash records.
What We Take from This:
- In the simplest terms, "volatility" means a stock moves up and down. All stocks are volatile. A stock that moves up and down more than most is "highly volatile."
- Using a conservative stop loss on a highly volatile stock is a mismatch of purposes. Either you should rethink your stop loss policy or stick with less intimidating stocks.
- It would be good to have a rule on this—how much volatility is right.
BigGains !!
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