Volatility is not a quality most investors look for when making an investment, but a segment of speculators -- known day and swing traders -- do rely on short-term volatility to earn a profit. Trading in volatile stocks is risky, however, because price movements become increasingly unpredictable as the time needed for exacting a profit shortens. In addition, trading on volatility requires that more positions are entered and exited, often counting into the dozens within a period of days or weeks. This means that traders must be efficient or they risk having transaction fees gobble away hard-earned profits.
Speaking to a group of business students, famed investor Warren Buffett once intimated, “I always say you should get greedy when others are fearful and fearful when others are greedy.” His advice refers to the influence of investor psychology on the behavior of stocks and markets and the phenomenon of “herd mentality” that occurs among investors. Fear, greed and uncertainty drive this mentality, and it is one of the most difficult aspects to overcome when trading volatile stocks. To avoid trading on emotion, and falling victim to herd mentality, professional traders rely on well-developed trading systems.
Trading systems are constructed from a collection of rules designed to enable the trader to locate and enter high-probability trades. There are no sure bets in the stock market, so professional traders inspect technical and fundamental criteria to locate behaviors and conditions they believe to be probable, recurring and profitable to trade on in the future. From this analysis, rules can be created that signal when it may be ideal to enter and exit positions in a stock. The final step is extensive testing of the system, usually against historical data or simulated markets.
Upswings and Downswings
Volatile stocks are defined by “swings,” or upward and downward movements in price that often result in the stock making little progress over periods longer than each swing. Because of these chaotic price movements, traders must use tools that allow them to profit on movements in either direction. Virtually all traders are familiar with “going long,” or buying a stock with the goal of selling once it appreciates in value. The opposite of this is “going short,” which is a method of profiting from stocks that depreciate in value by first selling shares of unowned stock (by borrowing them from another shareholder) and replacing those shares when they may be bought at a lower price later.
Leverage is another tool used by traders to maximize returns on short-term trades, as it allows a trader to profit even from small movements in the security. One way to gain leverage is to borrow funds that allow for a substantial increase in the size of an investment, known as buying “on margin.” Another approach is to purchase short-term investments known as options. Options provide the right for an investor to force the option's creator to either buy or sell the underlying security at a specified price, based on the terms of the option contract. For a small price, known as the option's premium, a notable profit can be earned, but only if the stock's price moves enough before the option expires. For this reason, volatile stocks are considered desirable by stock-option speculators.
- New York Magazine: Warren Buffett -- There Is Nothing to Fear But Fear Greed Fear
- A Random Walk Down Wall Street; Burton G. Malkiel
- Getting Started in Swing Trading; Michael C. Thomsett
A Florida native, Doug Wetzel has a background in both finance and technology ranging from investment banking to CTO and director of research and development for a NASDAQ company. Since 1994, Wetzel has also been a technical writer, authoring white papers such as DCTI's "Credit Card Fraud," and Web articles for AnswerBag and eHow.