Volatility and risk in stockmarket trading

If there is one area that is regularly ignored bywhich is important for CFD traders, and a beta of
CFD traders it is that of volatility, which is oftenmore than 1 suggests greater volatility than the
confused with risk. Certainly in terms of gradingbenchmark, with a beta of less than 1 suggesting
different types of asset classes, the two arelower volatility.
connected, and both the risk and volatility of aA stock with a beta of 2 for instance would be
government stock for instance will usually beexpected to move 2 times more than the
much lower than say a or emerging marketbenchmark, or double the underlying index move.
smaller company.Clearly if a CFD trader has a balanced list of
But the bottom line is that risk is related topositions in terms of longs and shorts, the
reward, and it simply measures the amount thataverage beta on each side needs to be assessed
it is possible to lose within each investment orin terms of the overall risk of big market moves
trade. Volatility however measures how muchin one direction.
prices rise or fall over a set time for eachNormally, but not always, the highest beta stocks
investment issue, sector or share, and this is veryare those with the greatest volatility as measured
useful when constructing portfolios, assessingby the standard deviation, but also how much
margin requirements and position sizing.they are affected by the business cycle and
Standard Deviation - the basic measure ofinterest rates. Fund managers, housebuilders and
volatilityinsurance companies for instance have much
Standard Deviation is the basic statistical measurehigher betas than supermarkets, pharmaceuticals
of the dispersion of a population of dataand utility stocks.
observations around a mean (average), and isIn portfolio analysis, the beta coefficient, or
widely used in stockmarket trading, forex andfinancial elasticity (sensitivity of the asset returns
commodity analysis. It is simply the square rootto market returns and relative volatility), is a key
of the variance, and is calculated as follows:parameter in the capital asset pricing model and is
1. Establish the mean value over the chosen timea way of separating an investor's profits related
period.to market action as opposed to the willingness to
2. Measure the deviation of each data point fromtake risk. In essence this means how much added
that mean.value there has been as opposed to just the luck
3. Square each deviation (this ensures all thefrom being in rising markets.
deviations are positive).If one is highly bullish about the underlying market,
4. Total up the squared deviations.it makes it easier to beat the market over the
5. Divide that figure by the number of data pointsterm in question by choosing high beta stocks.
less one.Equally, if a big fall is expected imminently, a CFD
6. The Standard deviation is the square root oftrader might prefer to take low beta long
that figure.positions and high beta shorts if a balanced trading
There are some variations on the way the STDlist was required.
can be constructed, but the above is the usualThe average true range indicator
formula supplied with most trading softwareThis is an important indicator that can be used for
systems.setting stops and is also another way of
Problems with standard deviationmeasuring volatility, and is included in most
1. If using short term action, the validity of thesoftware systems.
STD becomes less certain due to the usual shortThe ATR determines a share's volatility over a
term randomness in the market.set period that can be defaulted as desired. The
2. It is a retrospective measurement, and is ofdaily ATR indicator is very simple to calculate and
little use if there is a major change in volatility dueis the highest of:
to outside news. Having said that, there areThe difference between the current high and the
certain technical buy and sell indicators whichcurrent low
search for changes in volatility to establishThe difference between the current high and the
potential new trading opportunities, and here it isprevious close
very useful.The difference between the current low and the
Implied Volatilityprevious close
Many traders in the options markets will be awareBasically this is the maximum range in which the
of the use of implied volatility in terms of optionshare has traded from the previous close to the
pricing, and here the trader can use both thecurrent high and low. The average is then taken
underlying price of the security and the prices ofover a set number of days (ten is often used),
puts (rights to sell) and calls (rights to buy) toand the stop is then calculated as a multiple of the
establish an expectation of future or impliedATR.
volatility.The reason traders like the ATR is that it
This creates arbitrage possibilities if the stock, orcaptures more intra-day information, while the
market, is incorrectly priced compared tostandard deviation only measures the volatility of
underlying options available in it, and theseclosing prices (although it can be refined to include
disparities often occur after big price moves orhighs, lows, etc).
panicky action. The formula for implied volatility isReasons for volatility and what to look for
much more complex, but it is an interesting areaOn a short term view, shares that have quotes in
for more sophisticated players to analyse, as itmore than one market or currency may exhibit
also includes dividend payments and interest rates.high volatility, but not necessarily a high beta. This
What is beta?is simply because of arbitrage possibilities, where
Beta is another measure of volatility, and whilsttraders buy the stock on one market and sell in
totally different from standard deviation, itanother to take advantage of price discrepancies.
nevertheless provides another angle in portfolio orChanges in technology naturally affect the
trade construction.volatility of individual stocks because it takes a
Standard deviation determines the volatility of awhile for this information to become available to
fund, market, sector or stock according to thethe wider investment community, so a period of
disparity of its returns over a period of time,volatility often ensues. Once the stock becomes
whereas beta determines the volatility inmore mainstream or loses its super-growth tag,
comparison to an index or other benchmark.volatility can often die down.
If an investor has a portfolio of shares with aNews-led events often lead to big changes in
beta of 1, this means that the list should generallyvolatility, again as traders and investors begin to
match the underlying movement in thatadjust expectations for future prices. This can
benchmark over time. It doesn't mean that it willinclude profit upgrades or warnings, unexpected
naturally perform better or worse on an individualchanges in economic policy, natural disasters or
stock basis, but if the FTSE 100 index was togeopolitical events.
rally by say 10% over one year, the portfolioIf the volatility increases for the same investment
with a beta of 1 would in total expect to improveamount, so does the potential risk and reward
by a similar amount.and trade sizes/stop losses should be adjusted
On a trading level, each stock has its own betaaccordingly for CFD traders.