In 2020 and early 2021, the global financial market was relatively volatile mostly because of the coronavirus pandemic. In early 2021, volatility escalated as the Wall Street Bets (WSB) crowd pushed ‘ganged’ up and pushed some of the most hated stocks like GameStop and AMC Entertainment stocks higher and then down.
There was also a lot of fluctuations in the cryptocurrency and some select commodity markets like silver.
In this article, we will look at why volatility is important and some tools to help you identify it.
What is volatility and what does it mean in stocks?
Volatility refers to a situation where the price of a stock rises and falls within a few minutes or days. This period can be highly profitable for day traders, who are not concerned about the long-term future of the company.
However, it can also lead to significant losses, especially when traders are not prepared or equipped to deal with it.
A good example of volatility in stocks is what happened with GameStop (GME).
For starters, GME is a large company in a traditional industry. It sells video games in stores at a time when many people are shifting to digital games. As such, many people strongly believed that the company would file for bankruptcy like other traditional retailers.
Therefore, many investors placed large short bets against the company. In 2021, many social media users started to hype the stock. Within a few days, the stock climbed from $17 to $483.
It then dropped to $38 and rose back up to $182. This is a perfect example of volatility in the stock market.
Causes of stock volatility
A common question among many traders is on what exactly causes volatility in the stock market.
First, as described above, there is the role of social media platforms like Stocktwits, Twitter, and Reddit. These platforms have become highly influential since almost 30% of all daily volume in the US is from retail traders.
Therefore, as a trader, we recommend that you have a feed of what is happening in these platforms.
Second, the overall macro environment tends to lead to volatility. For example, in March 2020, the coronavirus pandemic led to significant uncertainties. As a result, many investors rushed to sell their holdings while some traders bought the dips.
As a result, many share prices dropped sharply in the first quarter and parts of Q2. The chart below shows the performance of the S&P 500 index during that period.
There are other macro issues that lead to this kind of volatility. For example, during the Trump administration, the trade war led to volatility in some stocks. Also, wars and natural disasters like the Japanese earthquake led to intense activity in the market.
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Third, stocks tend to be volatile slightly before and after they release their quarterly earnings. Before earnings, some traders are trying to forecast how the firm will perform. And after earnings, the volatility happens as traders digest the number.
Other causes of volatility in stocks are analyst calls, mergers and acquisitions, and company-specific news like management changes and product launches.
Most importantly, activities in the bond market usually has impacts on the stock market. For example, when the yield curve inverts, investors tend to rush out of the market as they anticipate a recession.
Similarly, when bond yields rise, some investors usually exit high-volatile stocks for safe-havens.
Top volatility tools in the market
A common challenge among traders is on how to identify volatility in the market.
CBOE Vix Index
One of the best and most common tools used to measure this volatility is the CBOE VIX index. This is an index that looks at the performance of stocks in the S&P 500. When it rises, it is usually a sign that volatility will rise.
The chart below shows that the VIX has been elevated in the past five years. This is mostly because of Trump’s trade wars and the Covid-19 pandemic.
Fear and Greed Index
Another tool that can show you about volatility is the fear and greed index. Developed by CNN Money, this tool is made up of several sub-indices that gauge the sentiment in the market. The popular sub-indexes that comprise the index are stock price breadth, VIX, stock price strength, and junk bond demand among others.
A significantly low reading of the fear and greed index is a sign of fluctuations in the market.
Other technical indicators
There are other popular technical tools used to measure volatility. Among the popular indicators that can show you this are the Average True Range, Relative Volatility Index, Historic volatility, and Bollinger Bands, among others.
The chart below shows the S&P 500 with some of these indicators.
How to trade volatile stocks
With all this in mind, how do you trade volatile stocks?
As mentioned above, periods of high volatility can lead to significant profits to day traders. In fact, in 2020, many investment banks and hedge funds made billions of dollars in profits thanks to the volatility.
As a day trader, there are a few things you need to do to maximize your profits while minimizing risks during this period.
- Ensure that you are not extremely leveraged during this period. Doing so will ensure that you are not exposed to significant losses.
- Avoid short selling since the loss potential can be enormous.
- Always protect your account with a stop loss and a trailing stop loss.
- Avoid leaving your trades open overnight.
Volatility is an important thing in the market. Indeed, a few years ago, many hedge funds blamed the lack of volatility for their underperformance. However, it can also lead to substantial losses in your day trading process.
Therefore, we recommend that you use the best risk management strategies to reduce risks.
External useful Resources
- Volatility From the Investor's Point of View - Investopedia