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Simplified Fundamental Volatility – A Risk Measurement Tool

How best to measure volatility? As an options trader, you have to pay attention to implied volatility, but also to the underlying historic volatility. This determines option pricing as well.

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 is a key ingredient 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.

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