Stock Market Video The Three Monsters Under Growth Investors’ Beds
In Case of Doubt Sound Convincing
Volatility = Stock Price Movement
Volatility Has Doubled Since 1950s
Using Options to Reduce Volatility Risk
Every investor knows that a demon lurks behind every stock purchase—it’s an invisible force that moves your stock up or down on a daily basis, ignoring the underlying fundamentals of the company.
That demon is called volatility, and it is the same mathematical concept as the one that says today’s temperature might vary a few degrees one way or the other from yesterday’s or that today it might take you a few minutes more or less than yesterday to get to work. It is essentially random movement governed by the mathematical laws of chance.
That may not be comforting, but it is an everyday reality in investing just as it is pretty much everywhere else. It’s caused by the myriad of random factors that can potentially affect the momentary supply and demand for a stock. Examples include an estate in Florida that’s being liquidated for the heirs, a mutual fund in Milwaukee that is increasing its position to conform with its models or a computer in New York trading firm that is programmed to buy it at a certain price and sell it 10 seconds later at a different one.
Volatility is a relatively simple concept mathematically, but a very complex one to predict. It actually has a standard statistical definition and can be easily calculated for any stock. It is the variance or standard deviation of daily returns on that stock. To calculate it, you take the daily returns (i.e. +1.2%, -.8%, -.4%, +.6%) for a given period, square them, subtract them from the mean, take the square root, annualize it and voila, you have a number that represents historical volatility. A period of the last 100 days is commonly used for such a calculation.
If you performed this calculation for a number of stocks or for market averages like the Dow Jones Industrial Average, you would see that the results vary considerably from one to the next. Typical volatility for a broad market average like the Dow or the S&P 500 might be around 10%–12%, while a blue chip stock might be 25%, a small-cap stock might be 40% and a high-flying biotech startup might be 80% or more.
What’s more, the volatility of any given stock changes during the course of the year and over time. Since the number is calculated as a standard deviation, it can be interpreted as telling you that based on its last 100 days of price fluctuation, there is a 67% likelihood that its fluctuation over the next 12 months will be within that same percentage from the current price in either direction.
A humbling thought, isn’t it? It means that while we hope a stock might gain a respectable 10%–15% in a year, it may easily be expected to move two to three times that much in either direction over the next year.
Now you understand why mutual funds and other institutional investors maintain portfolios of 100–200 stocks—to offset the mathematical volatility of individual stocks by combining a sufficient number of them into a portfolio whose volatility resembles that of an index. (The volatility of a large number of stocks is always less than that of individual components because the random individual movements tend to offset each other.)
Thus, one way to lower the day-to-day volatility in your portfolio is to simply increase the number of stocks you own. But there is more disconcerting news about volatility: It has been steadily increasing over the last half century, and is currently averaging about twice the magnitude it exhibited back in the 1950s (see the chart of S&P 500 volatility below). The trend line was around 10% back then and is closer to 20% now, though you can see how even overall market volatility can dramatically change from month to month.
For a little perspective on this, the average annual return on stocks over the last 100 years has been around 9%–10% per year (though not during the last decade, as we are well aware), yet the statistical variations in the market’s returns are now double that.
This raises the question: How much statistical variation should we be willing to accept in order to achieve a 10% return per year over time? If I said plus or minus 20% per year due to random fluctuation, would that be somewhat unsettling?
Now that I’ve probably added to your wariness about stock investing, let me give you the good news. There are ways to deal with, and even potentially profit from, volatility. One way is through diversification as I already illustrated. Another is through options.
Options are derivatives of stock and their prices are very strongly related to the amount of volatility in their underlying stocks. In fact, options prices not only reflect a stock’s characteristic volatility, they reflect the market’s expectation of the stock’s future volatility, which can provide valuable insight on the prospects of owning that stock.
You don’t have to trade options to gain insight from them. A quick glance at the options prices on any given stock (assuming you know what to look for) will give you a window into the stock’s characteristic volatility. From there, you can determine its relative volatility to other stocks in its sector or to the market as a whole. Deeper analysis can tell you whether the volatility over the coming weeks or months is expected to be higher or lower than it has been over the last several months or over a longer historic period.
Armed with this information, there are strategies that you can employ to sell options against stock positions in order to reduce the volatility in the underlying stock, and other strategies that can exploit distortions in volatility caused by news or other events.
Institutional and professional investors have used options for such purposes ever since they began trading on formal exchanges in the mid-1970s. These are option strategies that reduce the risk and volatility in a stock portfolio, and individual investors can use them also. It just involves a bit of education and the guidance of an experienced options professional.
We are currently bringing this expertise to Cabot subscribers through the Cabot Options Trader, and are looking to expand that service for stock investors who want to lower the volatility of their holdings or protect those holdings against undue downside risk.