Enough of the theory. The best way to use volatility to improve your trading is to make your profit-taking objectives and your stop-loss targets get closer and farther away as volatility decreases and increases.
Changing Profit Targets Based on Volatility
If AOL is trading in a $1 range each day, you might want to target a short-term profit of $2. That would be reasonable if prices moved in one direction for about three or four days. If AOL was much more volatile, ranging $4 in one day, then an equivalent profit target would be $8. More important, if volatility dropped to $0.50 then a profit target of $2 would take much longer to reach and you’ll want to set your goal at $1.
When you set your profit target by finding a resistance level on a chart, the volatility of prices tells you where to look. Don’t pick a minor resistance level that’s $1 above the current price when the market volatility is $2 a day, and don’t expect a profit of $10 when prices only range $0.50 each day.
Changing Your Stops to Reflect Volatility
The same principle applies to stop-loss orders. If the stop is inside the normal daily trading range of AOL, then you can be sure that you’ll be stopped out. How far away should you place your stop? Look for a support level at about 3 times the volatility below where you enter your long trade and place your stop-loss on either side of that level—depending on whether you are looking for free exposure or confirmation.
If you’re a technical trader and you are not using charts, then you can set your profit target and stop based entirely on volatility. If you have just entered a long position in AOL at $15 and the stock has been trading in a $1 daily range, then:
You’ll note that the profit target is 2 times the volatility and the stop is 3 times the volatility. The profit target is closer than the stop-loss. This is the normal pattern when you’re a short-term trader. You want to be sure you capture profits as often as possible. To do that, you’ll need to take a larger risk on each trade. If you make your stop closer than your profit target, then you’re sure to be stopped out more often and end up as a loser. The closer order is most likely to be hit.
Changing Profit Targets Based on Volatility
If AOL is trading in a $1 range each day, you might want to target a short-term profit of $2. That would be reasonable if prices moved in one direction for about three or four days. If AOL was much more volatile, ranging $4 in one day, then an equivalent profit target would be $8. More important, if volatility dropped to $0.50 then a profit target of $2 would take much longer to reach and you’ll want to set your goal at $1.
When you set your profit target by finding a resistance level on a chart, the volatility of prices tells you where to look. Don’t pick a minor resistance level that’s $1 above the current price when the market volatility is $2 a day, and don’t expect a profit of $10 when prices only range $0.50 each day.
Changing Your Stops to Reflect Volatility
The same principle applies to stop-loss orders. If the stop is inside the normal daily trading range of AOL, then you can be sure that you’ll be stopped out. How far away should you place your stop? Look for a support level at about 3 times the volatility below where you enter your long trade and place your stop-loss on either side of that level—depending on whether you are looking for free exposure or confirmation.
If you’re a technical trader and you are not using charts, then you can set your profit target and stop based entirely on volatility. If you have just entered a long position in AOL at $15 and the stock has been trading in a $1 daily range, then:
Profit target = entry price + (profit factor × daily range)
= 15 + (2 × 1)
= 17
Stop-loss = entry price − (stop factor × daily range)
= 15 − (3 × 1)
= 12
You’ll note that the profit target is 2 times the volatility and the stop is 3 times the volatility. The profit target is closer than the stop-loss. This is the normal pattern when you’re a short-term trader. You want to be sure you capture profits as often as possible. To do that, you’ll need to take a larger risk on each trade. If you make your stop closer than your profit target, then you’re sure to be stopped out more often and end up as a loser. The closer order is most likely to be hit.
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