Stock Exchange: Is Volatility Your Friend Or Foe?

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Includes: AGN, CDW, LHX, VMC
by: Jeff Miller
Summary

Volatile market sell-offs can bring pain and opportunity.

At the very least, investors and traders should be aware of what volatility can do to their portfolios.

Our regular participants share trading ideas, reflecting their contrasting styles and time horizons.

The Stock Exchange is all about trading. Each week, we do the following:

  • Discuss an important issue for traders,
  • Highlight several technical trading methods, including current ideas,
  • Feature advice from top traders and writers, and
  • Provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links and ideas to help us improve this resource for traders. If you have some ideas, please join in!

Review: Are You Growing Your Trading Knowledge Base?

Our previous Stock Exchange asked the question: "Are You Growing Your Trading Knowledge Base?" We noted that Kaizen is a Japanese word often used in business meaning “continuous improvement.” And we asked whether you are continuously improving your own trades, or at least looking for ways to continuously improve? We also welcomed a new trading model to The Stock Exchange, Emerald Bay.

This Week: Is Market Volatility Your Friend Or Foe

Whenever market volatility kicks up, so does fear and greed. While many investors view market volatility as the enemy, others view it as an opportunity. For example, on one hand, if you're counting on your nest egg to provide you a secure retirement, it does not feel good to see markets sell off, thereby eating into your nest egg. On the other hand, some traders view volatility as an opportunity to buy things on sale.

For a little perspective, here is an image of recent market volatility, along with a quote from legendary trader, Charles Kirk.

"With last week's improvement, the S&P 500 is now down -3.4% from the intraday July high at S&P 3027 after being off -6.8%at its worst level at S&P 2822 in early August... From this big picture perspective, markets are only slightly down from their summer high in spite of a far more volatile, more challenging environment."

Our own technical models trade based on volatility in varying ways. For example:

  • Road Runner purchases stocks after they've experienced some downward volatility within a rising momentum channel.
  • Emerald Bay bases position sizes on volatility, with more capital invested in the less-volatile stocks.
  • Several of our models will use stop loss orders calibrated to current levels of market volatility.

Still other traders view price volatility as simply a source of trading mistakes. For example, selling into a sell-off out of fear, or buying into momentum for fear of missing out. How do you view market volatility?

Model Performance

We are sharing the performance of our proprietary trading models as our readers have requested.


The models are based on a variety of trading strategies as we will review later in this report. They are also often used in combination with our longer-term fundamental investment strategies.

Expert Picks From The Models

Emerald Bay: I wanted to highlight a couple positions I purchased on August 21st, Vulcan Materials (VMC) and L3Harris Technologies (LHX).

Blue Harbinger: You again, Emerald Bay. This is your second week sharing trades and you're acting like you've been here forever.

EB: Well, as was mentioned earlier in this report, I like to base my position sizes on volatility with more capital invested in the less-volatile stocks. So, I guess you could say volatility is neither my friend or my foe. It's just another metric I keep a close eye on.

BH: Interesting stuff, especially since I recall you are a momentum trader too. Anyway, how about you, Road Runner - any volatility-related trades you care to share this week?

Road Runner: I bought shares of CDW Corp. (CDW) on August 29th. What do you think about that?

Blue Harbinger: Why'd you buy, Road Runner?

Road Runner: As you know, I like to buy momentum stocks in the lower end of a rising channel. You can see what I am talking about in the following chart.

Blue Harbinger: You do know that CDW provides IT solutions out of Lincolnshire, Illinois. Not too far from where Jeff lives, right?

Road Runner: I know what CDW does, but I am more interested in the technical price action. Besides just buying in the lower end of a rising momentum channel, I look for a certain type of situation (some call it a pattern, others may call it a setup, etc.) where the probability of a particular action is not a matter of chance (50/50) but has been historically noted to result in a greater tendency toward a particular outcome. “Trending in a channel” is one such situation. An equity will often “cycle” between the upper and lower bounds of that channel for substantial periods of time.

My model design attempts to take advantage of this property by identifying stocks trending in an upward channel and waiting until the stock price drifts to the lower bound, making it a candidate for purchase. These types of situations have a relatively high probability of positive outcome with a reasonable profit potential. And CDW can be seen to be in this type of a situation. This is a short-term trade that has traditionally shown profitability when the right conditions have been met. One way or another, I'll be out of it shortly - usually after about four weeks.

Blue Harbinger: Okay, thank you for sharing that information. And how about you, Athena - any trades to share with us this week?

Athena: I bought shares of Allergan (AGN) on 8/30.

Blue Harbinger: Kind of bold to be buying a pharmaceuticals company, Athena, don't you think? With all the pressure on healthcare costs, combined with healthcare law uncertainties, not to mention the constant threat of lawsuits. Here is a look at some of Allergan's fundamental data in the following F.A.S.T. Graph.

Athena: Thanks. Interesting talking points.

Blue Harbinger: They're more than just talking points, Athena. Besides, analysts don't love it. In fact, of the 16 Wall Street firms reporting to FactSet, fewer and fewer have been rating it a "Buy" over time, as you can see in the graphic below.

Athena: You and these fundamental narratives again. You can make up a story for anything. I, however, am an emotionless trading model unaffected by your subjective narratives. I stick to the technical data. Specifically, I look for stocks having strong positive trends and then select only those with the very strongest trends ("king of the hill"), constantly replacing the ones with weaker trends. And I generally continue to hold my positions until either the strength of the trend abates or a stock with an even higher trend strength comes along. I don't have a set "holding period" for a position. I will exit only when either a stronger stock comes along or if market conditions dictate a strong potential for loss - capital preservation remains the key driver in all situations.

Blue Harbinger: It's not a subjective narrative. These are Wall Street estimates based on lots of fundamental research. They are very detailed - they even share estimates for sales by product segment, as you can see in the following graphic.

Athena: Yawn. Those sell-side analysts are so conflicted. They sugarcoat everything because they want lucrative Wall Street business from Allergan for things like underwriting new bond issues and providing investment banking for mergers & acquisitions.

Blue Harbinger: Ha. You have a lot of character for a computer model, Athena.

Conclusion

Volatility can bring headaches, heartbreak and happiness, depending on how you view it. It seems obvious that no one likes a volatile market sell-off, unless you're holding un-invested cash that you can put to work at the new lower price (or perhaps you're an ugly short-seller). At the very least, you should be aware of what volatility can do to your nest egg if you're allocated incorrectly or prone to making silly mistakes, like chasing volatile market gains out of greed or selling at the bottom out of fear. But, of course, it all depends on your view. How do you view market volatility, as a friend, a foe or something else?

Getting Updates

Readers are welcome to suggest individual stocks and/or ETFs to be added to our model lists. We keep a running list of all securities our readers recommend, and we share the results within this weekly "Stock Exchange" series when feasible. Send your ideas to "etf at newarc dot com." Also, we will share additional information about the models, including test data, with those interested in investing. Suggestions and comments about this weekly "Stock Exchange" report are welcome. You can also access background information on the "Stock Exchange" here.

Trade alongside Jeff Miller: Learn more.

Disclosure: I am/we are long LHX, VMC, CDW, AGN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.