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Stock Ideas Investors Daily Edge How To Read Stock Volatility by Charts
Stock Ideas Investors Daily Edge How To Read Stock Volatility by Charts 
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By Andrew Mickey Chief Invest Investment Strategist, Q1 Publishing The financial world didn’t get its relief yesterday. The bailout plan and any accompanying reprieve just weren’t in the cards. The Dow tumbled and investors rushed to the exits. I’m not going to harp on the bad news again, I’m sure you’ve heard it all by now. That’s because opportunity is knocking right now. |
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| How To Read Stock Volatility by Charts |
| Thursday, 08 May 2008 | ||||||||
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It’s volatility again, part two of a subject you probably didn’t realize you’d be dying to know so much about. Last week, we took a look at how you can accidentally hurt yourself when you mismatch a high-volatility stock with a stop loss. This week, we’ll discuss an easy way to keep you out of that kind of trouble. Very volatile stocks aren’t just likely to trip your stop losses—if you even use stop losses—they also tend to look like they’re about to drop dead a few times a year. You see this, you sell the stock, and then the next week it’s back setting new highs and you’re groaning. So now, let’s look at how to measure volatility. If volatility is simply a lot of movement, does that mean a lot of dollar points up and down each day? A large percentage of its stock price each day? Or, a lot compared to an index? All those possibilities contribute something to the story. But the most intuitive place to start is with how much a stock goes up and down in price. We would accept gigantic moves to the upside, of course. But how much movement the wrong way are we courting to get that? Is the stock likely to gain or drop $5 in a single day on a regular basis, or only 75 cents in a normal swing? There is a very simple way to check this. It’s free. If you have a computer, you can get the facts at Stockcharts.com easily. Another free source is Incrediblecharts.com. The tool you want is called “average true range,” or ATR. Let’s take a look: Here’s a nice little biotech that is well established, Gilead Biosciences. On this chart, the ATR for Gilead was about $1.30 a day last November and $1.70 in March. If all you want to know is how volatile your stock is, you can stop right here. You now have a tool you can use. Vaya con dios and prosper. If you want to learn a little more about where ATR comes from and what else it can predict, read on…
 Gilead is a pretty busy stock, but even so, it’s not often that it moves up twice its ATR or more within two days. It’s even more rare for it to fall that much in two back-to-back days. Now that you’ve seen your first chart. Let’s look at ATR itself a little more closely. The ATR is calculated over a set period. Usually, it’s a 14-day average of the true range. A “true range” is not a complicated statistic. It is simply how much a stock changes in a day. So it can be calculated as- Today’s high minus today’s low (that is, the whole range for today) Today’s high minus yesterday’s close (how much it went up since yesterday, if that’s more than today’s range) Or today’s low subtracted from yesterday’s close (how much it went down since yesterday if the stock is falling). To put that in a picture, the ATR is between the dotted lines in each of the three examples here:  You don’t have to struggle with remembering that now that you have an idea what a true range is. It’s just today’s high to low, or the amount it went up or down since yesterday, if that’s a bigger number. Chart software will do all the calculating for you, anyway, but you know enough so this tool is not mysterious anymore. That’s all that’s necessary. I began looking at ATRs years ago when trying to figure out whether a stock was likely to move enough in the short run to make an option pay off. From looking at hundreds of charts over the years, I developed a seat-of-the-pants notion that two times the ATR was a significant number I could use. Even on a biotech stock, and much more so with blue chips, it is quite rare for a stock to move its full, current ATR range one day then continue in the same direction for an additional full ATR move the next day. And doing it with no backtracking or overlapping in price for three or four days is exceedingly rare. It seems that two back-to-back full-ATR moves down (or three up) is about all you can expect from the stock’s normal behavior. After that, the stock usually reverses course or stands still for a while. This then gives you an idea of what kind of sudden wrong-way movement you might have to put up if you buy a particular stock. My two-times-ATR rule is just a rule of thumb I developed as one of my personal shortcuts. It has no textbook blessing that I know of. But it seems to have a bit of a pedigree after all. As it turns, the notion I adopted in practice must have hit some other chart watchers, because the idea is also woven into a couple of technical indicators for “price channels.” The best-known indicator to use the two-times-ATR idea is the Keltner channel. And you can get those on stockcharts.com, too. (In case you wondered: A Keltner channel is made of two bands around the price. The upper one is two times the ATR added to a 20-day moving average. The lower band is two times ATR subtracted from the moving average.) Here’s something else for you. Watching ATR to gauge volatility can add to your market moxie: when a stock exceeds its own volatility habits—that is a two-day move of more than twice ATR—it tends to stop and go sideways. To show you this, I am going to give you another chart—this one with the ATR graph below it and the Keltner channel band shown around the price. In this chart, the two-ATR days had a small overlap. As I said, it’s hard to find two consecutive days that move down by the whole ATR amount without any backtracking or overlap. But look at this Coca-Cola chart:  So you now have two tools you can use before you buy a stock to see what kind of volatility you are likely to get: the ATR and Keltner channels. Stockcharts offers both. Of course, ATR changes over time, and when it is getting larger, the stock is becoming more volatile. It is probably getting into a stronger trend, too. But if you look at most stocks over a long period, they tend to stick within a limited range of ranges, so you can still get a good idea what you are in for. Even on the Coke chart, you can see that the stock doesn’t move up to a $3.00 ATR. Some tools are for choosing good stocks. Volatility is not one of those, though it is sometimes misused that way (we’ll get to that when we get to the academics later on). It has nothing to do with the company’s quality or its earnings potential. But it will help you anticipate the range of normal movement to be sure you are choosing a stock you can stand to live with. What We Take from This: This is about knowing what to expect from a stock, not picking the best one. To get a measure of what’s normal for a stock, look at its ATR on a chart. Assume that you will sometimes see the stock drop twice that amount in a couple of days. Two times ATR should be considered a routine zigzag, even when the stock is bullish overall. If that’s more adversity than you want to experience, don’t buy the stock. Stocks rarely drop more than two full ATRs over consecutive days without a rebound of at least a day or two, maybe longer. But when they do fall more than two ATRs in consecutive days, or hit the lower Keltner band, the stock will tend to go sideways a while. Of course, a two-dollar a day move means something quite different on a $40 stock and an $8 stock. But that’s for next week in our volatility series. Respectfully, Lynn Carpenter P.S. To let me know what you thought of today's article, send an e-mail to: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
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