What is Volatility in Stock Market?
One day a friend of mine asked me “Is it only me or the market always hits your stop loss?”. What could be the reason for this?, I asked him.
“Volatility” he said.
This made me ask him, what he meant by volatility and to my surprise, he had no convincing answer.
“Volatility” is a word used by many traders but truly understood by a few.
Simply put, it is the range of price change experienced by any financial instrument over a period of time.
For example, let us say a stock has an average daily range of 1% but is moving 3% on an average from the last 1 week.
We can say that the volatility has spiked up in that particular stock as it is fluctuating more than it generally does.
What is the reason for the spike in volatility? asked my friend.
Fear and Greed, I said.
When traders fear a crash they sell in panic and buy due to greed when they expect an up-move. Significant price movements are a result of emotions and human psychology.
Knowing how to use volatility in your favor can help you avoid losses in such times.
Average true range (ATR) is one such indicator that measures volatility and can be used to place stop losses in view of stock volatility.
Simply put, ATR measures the average movement of a stock in the last 14 days (by default).
For example, the ATR of HDFC stock is 83 points. So, if we put a stop loss of 10 points there is a good chance that it will be triggered.
It is wise to place your stop at 2 times of ATR, thereby, reducing the chances of taking a loss just to see the trade move in your favor after that.