Stock Images Stock Market

Breadth Of Trading - The Stock Volatility Affects Options Premium Levels

A stock's historic volatility measures its tendency to move up or down in price. Faster and larger movements in price represent high volatility and unpredictability for a company. Volatility, in fact, is the most reliable indicator of market risk.

Under the formula used to measure volatility, the standard deviation in price change serves as the basis for identifying the percentage of volatility. But is this the most accurate method? The problem with any unadjusted statistical average is that it does not account for price spikes, which distort the picture.

For example, a stock's price range over the past 52 weeks has been between $50 and $55 per share. About six months into the year, a rumor was floated that the company was the target of a merger and that the price that was to be offered was $62 per share. The price spiked up in one day, and then returned to its previous range when the rumor turned out to be unfounded.

This price spike will distort the calculation because it creates a wide divergence in price even though it was not valid. A more accurate method would be to eliminate the price spike and then calculate volatility.

The method of calculation can be inaccurate if the price is distorted during the period under study. Many investors also misunderstand volatility, thinking it is the same as a stock's beta. Volatility measures the degree of price movement, while beta measures a stock's price reaction to price changes in the broader market.

Measuring volatility is crucial for several reasons. First and foremost, it quantifies risk. Second, high volatility can affect both profitability and cash flow, based on investor perceptions about a company's overall stability. Third, speculation based on volatility may itself affect the price of stock in the short term, further distorting volatility over the longer period.

Volatility one of many key ingredients in stock selection. However, it should be measured accurately in order to be useful. This means removing price spikes and studying the entire year's volatility rather than only the past month or two. In addition, it is important to realize that volatility and beta are entirely different measurement. Finally, a distinction should be made - but often is overlooked - between price volatility and price direction.

Price direction may have growing or shrinking momentum, and that is an important consideration in selecting and timing the purchase of a company's stock. Volatility measures the degree of change, but does not predict price direction. In fact, fast up-and-down price movement may result in high volatility but no directional change of significance.

Considering the flaws of statistical measurement, an alternative method of calculating volatility makes sense. Based on the breadth of the current trading range, you can plot growing or shrinking volatility. Here are the steps:

1. Calculate the point difference between resistance and support.

2. Divide the point difference by the average price per share within that range.

3. Compare the percentage above to the same calculation a year ago.

This system is simple but it identifies the change in momentum and volatility over time. For example, a stock trading between $55 and $65, or a 10-point difference, is calculated as having volatility as:

($65 - $55) $50 = 20%

If the stock trades at a much lower or higher average price, volatility is different as well, even if the price range is the same. For example, the current trading range moves between $32 and $24:

($32 - $22) $28 = 36%

If the current trading range moves between $120 and $110:

($120 - $110 ) $115 = 9%

Using this system as an alternate enables the calculation of averages and also identifies the immediate volatility risk based on the trading range. But for options, traders, what does all of this mean?

The underlying volatility is most visible in the breadth of trading, and options traders realize that the reliability or consistency of breadth defines option premium. So for many more conservative traders, the first step is picking the stock; and only then do you consider what types of options traders to enter.

Testing underlying volatility is a good first step, along with a few other fundamental tests. After you narrow down your list based on these criteria, then you should consider trading options appropriate to your risk tolerance. This is the test I perform as a first step in picking stocks I trade in the virtual portfolio I manage at ThomsettOptions.com - but that only narrows down my list of high-quality stocks with moderate to low market risk. I then test various kinds of options trades timed for the price swings within the trading range. I hope you will visit the website and see how I detail the stock charts to explain the timing of my trades. Come to http://tinyurl.com/aqeeops and see how the portfolio is doing. You can also sign up there for a free weekly newsletter about trading options.

By Michael C. Thomsett - Professional author specializing in consumer personal finance, risk management, and investing; author of more than 70 books.  





Receive Our Free Gifr


Make Money with Clickbank



video lesson ipads ipad pete

FOR THE FIRST TIME... I Am Going to Trade Live Online Daily and Email
my Trades to you, and give you my FOREX TRADE COPIER SOFTWARE.
Buy




Recommended Products




fap turbo flash forex forex trendy binary options trading signals

Next page: Stock Price


Bookmark/Share This Page:

ADD TO DEL.ICIO.US ADD TO DIGG ADD TO FURL ADD TO NEWSVINE ADD TO NETSCAPE ADD TO REDDIT ADD TO STUMBLEUPON ADD TO TECHNORATI FAVORITES ADD TO SQUIDOO ADD TO WINDOWS LIVE ADD TO YAHOO MYWEB ADD TO ASK ADD TO GOOGLE ADD TO MAGNOLIA ADD TO NING ADD TO RAWSUGAR ADD TO SPURL ADD TO TAGTOOGA

  Bookmark and Share


Stock Images News


Norway’s $1 trillion wealth fund looks to dump oil & gas stocks

The global campaign to divest from fossil fuels may have just picked up its most significant ally to date – the largest sovereign wealth fund in the world. Norway’s trillion-dollar sovereign wealth fund has proposed dropping investment for oil and gas ...

Read more...


houseplangallery.com

fouryoursucess.com

Receive Our Free Gifr