The markets have certainly been volatile lately. This is a comment that you may hear on a regular basis and it is often used to describe a share or market when it falls sharply, but what does it really mean? And more importantly, how can we use an understanding of volatility to improve our trading?
Volatility is the fluctuation in share price as measured over a period of time. If one share moves in a range of 20 cents in a week and another share moves in a range of $1.00 in a week, this would be considered a more volatile share. Note that this says nothing about the direction of the movement, just the range of movement. This is one way to measure volatility and there are many other ways to measure it as well.
The average true range (ATR) is a measure of how volatile a share is on a daily basis. The true range is the movement from the high of the day to the low of the day including any gaps that may occur. The average true range is the true range, averaged out over a number of time periods. In Computershare, shown in the chart below, the ATR(10) varies from a low of 10 cents to a high of more than 30 cents. A spike in the ATR has occurred recently following the announcement that Computershare has gained approval to take over a US based share registry. Looking closely at the chart you will see that when the volatility spikes it can be a sign that the share is about to reverse direction as it did in May and August this year, but the reversal was slower coming in January.
Statistically speaking the range can be defined by the standard deviation, which is the range required to contain a certain percentage of price movement. 99% of price movement is contained within 2 standard deviations of the current price, so only in very rare cases will the price move beyond 2 standard deviations. Bollinger Bands display two bands that are 2 standard deviations from the current price as shown on the chart below. When the bands tighten up the volatility is low and when the bands widen out volatility has increased. As you can see in the chart below volatility has increased sharply following the announcement. From a trading perspective, when the share price breaks outside the band then expect a reversal as can be seen in August, September and October and again recently.
While these measures can easily be applied to an individual share there is a more sophisticated way to look at volatility which is more informative than a simple mathematical calculation. The volatility index, known more widely as the VIX, measures the premium that is being paid to purchase options on the S&P 500 index. To correctly price options it is necessary to take into account the volatility of the underlying market. If option prices spike then it is a sign of an increase in volatility in the market. In Market Analyser the volatility index is accessed by the code .VIX and the underlying index is the S&P 500 .INX. Both of these can be displayed on the same chart using the Overlay security function.
The VIX is shown in pink on the chart overlayed on the S&P 500. Volatility has certainly been higher during the last 4 months than in the few months preceding it based on the VIX. Note the turning points in the index often coincide with the turning points in the VIX. Once the index reaches an extreme a reversal is imminent. High readings in the VIX correspond with points where the market turns higher and low readings in the VIX can signal sharp drops.
Using these tools you can measure whether the market is volatile right now and also use this knowledge to assist in identifying turning points in the share or market you are following.
By Jeff Cartridge
Education Manager
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Computershare was recommended as a buy by MDS Research Team at the start of November. You too can get advantage of our buy and sell recommendations on ASX listed companies by registering for a free trial of MDS Financial Research.
