Volatility is defined as the, “… Rate at which the price of the security increases or decreases for a given set of returns. Volatility is measured by calculating the standard deviation of the annualized returns every given period of time. It shows the range to which the price of the security may increase or decrease.” (The Economic Times)
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For a novice trader, volatility is particularly unnerving. Dramatic price fluctuations can seriously undermine an investment portfolio, often to the detriment of account holders. Volatility is praised when prices rise and securities appreciate in value, but it is eschewed when trends reverse in the opposite direction and depreciation of the underlying securities takes place. For better or for worse, volatility is an inexorable component of the financial markets, and indeed the global economic system. The definition pays tribute to important economic terms such as the standard deviation, the price range, and annualized returns. If wild price fluctuations abound, the underlying security is said to be highly volatile. By the same token, limited price fluctuations around the mean tend to indicate less volatility and more stable pricing mechanisms.
Heading into Q1 2020, the global financial markets were generally assumed to be in good shape. This comes with a caveat; the scales can be tipped at any point, by any number of variables including geopolitical events, economic shocks, technological innovations, or speculative sentiment. As a case in point, the stock markets in February 2020 are facing short-term selloffs and decreased demand, owing to the outbreak of the coronavirus and its ramifications on global demand. Markets across the board were subject to large-scale selloffs as investors weighed the pros and cons of the current pandemic. One of the most important trading tips to learn from the get-go is the following: Always set stop loss orders on your trades.
Why Are Stop Loss Orders So Important?
Every time you buy a stock, say AAPL (Apple Inc), you pay a certain price and that represents your baseline for the stock. That price is used to evaluate any gains or losses you may generate over time. The baseline price is also an effective starting point for evaluating safeguards on your investment. A stop loss order is one of the most ingenious innovations available to traders and investors today. It does precisely what its namesake suggests: it stops your losses once the market drives prices down towards your stop loss level. For argument’s sake, consider what would happen if you purchased 100 shares of AAPL at $317 per share. The cost, barring trading fees, commissions, and others would be approximately $31,700.
Now let’s throw in some volatility, perhaps from a deadly flu strain that has become a global pandemic, and see what impact this can have on the performance of AAPL, and your financial portfolio. In the absence of stop loss orders, the market value of your portfolio will fluctuate wildly. When the market is fearful, stock prices decline as traders and investors shift their resources from equities to safe-haven assets like gold bullion, gold stocks, or gold ETFs, as well as government bonds, fixed-interest savings accounts, or good old cash under the mattress. If you are determined to hold Apple stocks because you believe in the company’s potential as a proven performer, you would buy Apple stocks and set a stop loss order.
Perhaps your stop loss will be set at 10% below the market price, because you understand that volatility is an indelible characteristic of all market activity. If Apple drops by $32 per share, the stop loss order will kick in around that price and you will lose approximately $32 per share, ($317 -$31.70 = $285.30). It must be pointed out that your stop loss hardly ever coincides with an exact figure, because these orders activate during volatile trading activity and you may miss your price point by a few dollars. Assuming that everything goes like clockwork, the total value of your portfolio at the actual stop loss level would be $28,530, for a loss of $3170. It’s better than having no stop loss order in place and losing substantially more than that.
Granted, it’s pretty easy to manage a single stock without having to set a stop loss order, but it’s much better to use this powerful strategy since is automatically configured into your trading platform. If you have 10 stocks or even 100 stocks, this automated system pays for itself many times over. It is virtually impossible to simultaneously manage dozens of stocks during a market rout. You will lose the proverbial shirt off your back as a new trader and that’s precisely why experts recommend setting stop loss orders.
Impact of Speculative Sentiment on Trading Activity
The current global health crisis is a classic example of how speculative sentiment and fear are driving short-term market activity. The performance of bourses around the world, including the Dow Jones Industrial Average, the S&P/TSX composite index, the S&P 500 index, the NYSE, the NASDAQ, EuroStoxx 50 PR, DAX 30, CAC 40, FTSE 100, Ibex 35, Hang Seng index, and MSCI AC Asia Pacific index are down over the past 1 month. As a novice trader, the fear mongering on the floors of the world’s premier stock markets appears to be a harbinger of bearish sentiment, while in fact the opposite holds true. When speculators dump stocks en masse, savvy traders use this opportunity a.k.a. a market correction, to purchase high-quality stocks at cut-rate prices.
This is but one example of a highly effective trading strategy that novices can employ during times of volatility. Experienced traders understand the implications of speculative sentiment a.k.a. mass-market euphoria or panic on the prices of underlying assets. When the world gets excited about the economic performance of the US economy, or the Chinese economy, they tend to invest in securities over safe-haven assets such as gold and government bonds. This has a multiplier effect on the broader economy and the decisions of everyday traders and investors. By contrast, bad news results in accelerated selloffs of underlying securities. This is precisely what we are witnessing now. As a newbie in the trading arena, you may be weighing your options with respect to buy or sell decisions with stocks.
When is a good time to buy? When is a good time to sell? The issue of timing is sacrosanct in trading activity. Suffice it to say, it’s never a good time to sell when everybody is selling – that’s precisely the opposite advice that legendary investor Warren Buffett cautions against. In fact, it’s probably best to buy when everybody else is selling because that’s when you pick up great deals. By contrast, it’s always a good time to buy when you’ve conducted extensive research into an undervalued company. For example, many analysts believe that US banking stocks are undervalued and subject to upwards price corrections in times to come. This indicates that a purchase decision is the right decision moving forward. Of course, there are many other ratios to look at, including the price/earnings ratio – the lower that figure is, the more valuable the stock.
Top Trading Tips for Novices Wanting to Buy Stocks
- Established dividend stocks are always a much better proposition than stocks which don’t pay dividends because you will generate ongoing returns from the stock.
- EPS figures (earnings per share) matter. If you’re going to invest hard-earned money in a stock, it’s probably best if that company is going to generate favorable EPS for you.
- Analyst opinions carry some weight – so pick stocks that are viewed favorably by analysts because many other investors and traders like yourself often look towards analyst opinions to make their decisions.
- Check metrics like trading volume, average volume, and 52-week high and low figures. There is no substitute for informed decision-making when it comes to buying and selling stocks.
As a trader, you cannot to leave things to chance. You have to take power into your own hands by implementing effective trading strategies designed to grow your portfolio, or to protect it from further degradation in a bear market.