By the way, this volatility that we just unraveled is for the S&P 500 index itself. You could do the same for the Dow or any other index. You can do exactly the same thing for any stock. But be clear, this is NOT the oft-quoted VIX, which hogs the news. The VIX is found with the same kind of math, but it measures the movement of options on the S&P 500 index. Options are much more volatile than stocks, and unlike many others, I do not consider VIX nearly as valid a market indicator as regular volatility. But we’ll do VIX tricks some other time.

But the question is, why would we want to know this kind of “standard deviation” volatility, anyway? As it turns out, the volatility is interesting and very useful if you are planning short-term trading or options trading. For us, it is the standard deviation itself that is the better focus, because it is significant. Very significant.

It all comes back to the good, old “bell curve.” While individual stocks, not to mention the market as a whole, are somewhat less than perfect copies of theory, they do behave with pretty fair predictability that we can turn to our own uses. Very often, how much a stock returns is related to its standard deviation.

Source: Russell

On the grand scale of the S&P 500, this relationship has held up well over decades. About 68% of returns fell within one standard deviation of the mean, and 95% of the time returns were within two standard deviations.

For stocks, the relationship is a little flukier, but still very sturdy. This is why technical analysts like to look at Bollinger bands. They are lines on stock charts that are drawn exactly one standard deviation above and below a moving average.

I use Bollinger bands a lot. First of all, they tell me what range a stock is likely to move in. Second, they tell me if a movement exceeds the range of its standard deviation, and that matters because big moves are often followed by an opposite reaction.

But hey, that’s enough for this section. Let’s move on to the next article, and I’ll show you. I’ve been hinting that there’s a volatility tool with some predictive power—this is the one.

To sum up, we have a new volatility definition:

• “Volatility” unless otherwise noted usually means annualized standard deviation
• 68% of market returns tend to fall within 1 standard deviation of the mean
• 95% tend to fall within two standard deviations
• The standard deviation changes as the stock or index becomes more or less active, but “historical volatility” is normally calculated from the past 60 days. Other periods may be used as well.

Respectfully,

Lynn Carpenter

P.S. To let me know what you thought of today’s article, send an e-mail to: feedback@investorsdailyedge.com.

[Ed. Note: Optionist subscribers have already booked 15 winners in 17 weeks this year. These recent winners include 245% 105% 180%, 165%, 146% and 116%. Find out more about how you could tap into these superb gains right here.]

Source: Deviant Aspirations 

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