Trading Volatile Stocks With Technical Indicators

Volatility can be defined as the dispersion of returns for a given security or market index over a period of time. It is quantified by short-term traders, for instance, as the average difference between a stock's daily high and daily low, divided by the stock price.  A stock that moves $5 per day with a $50 share price is thus more volatile than a stock that moves $5 per day with a $150 share price because the percentage move is greater with the first.

Trading the most volatile stocks is an efficient way to trade because, theoretically, these stocks offer the most profit potential. Not without their own dangers, many traders seek out these stocks but face two primary questions: How to find the most volatile stocks, and how to trade them using technical indicators.

How to Find the Most Volatile Stocks

Finding the most volatile stocks is not very complex and no longer requires constant research or stock screening. Instead, you can set up and run an ongoing screener for stocks that are consistently volatile.

StockFetcher is one example of a filter you can use to track very volatile stocks. Applying customizable filters, Stock Fetcher will pick stocks with average moves greater than 5% per day (between the open and close) over the past 100 days.

Volume is also essential when trading volatile stocks, for entering and exiting with ease. You can use this tool to also filter stocks, for example, priced between $10 and $100 and with an average daily volume of over 4 million in the past 30 days. Furthermore, if you are only interested in stocks and not exchange-traded products, adding a filter like "exchange is not Amex" helps avoid leveraged ETFs that might otherwise appear in the search results.

A more research-intensive option is to manually look for volatile stocks each day. Finviz.com offers a free version that provides top gainers, top losers, and the most volatile stocks for each trading day. Use the screener tool to further filter results for market capitalization, performance, and volume. Narrowing the search in this fashion provides traders with a list of stocks matching their exact specifications.

Nasdaq also lists the biggest gainers and losers on the NASDAQ, NYSE, and AMEX exchanges. These are not filtered results and only reflect volatility for that day. Therefore, the list provides potential stocks that could continue to be volatile, but traders need to go through the results individually and see which stocks have a history of volatility and have enough volume to warrant trading.

Trading the Most Volatile Stocks

Volatile stocks are prone to sharp moves, which requires patience when waiting for entries but quick action when those entries do appear. Certain indicators can be used to trade volatile stocks, but the trader must also monitor price action—watching if the price is making higher swing highs or lower swing lows, relative to prior waves—to determine when indicator signals are taken and when they are left alone.

Below are just two technical indicators you can use to trade volatile stocks, along with what to look for in regards to price action.

Keltner Channels

Keltner channels put an upper, middle, and lower band around the price action on a stock chart. The indicator is most useful in strongly trending markets when the price is making higher highs and higher lows for an uptrend, or lower highs and lower lows for a downtrend.

During a strong uptrend, the price will "ride" the upper Keltner channel, and pullbacks will often barely reach the middle band and not exceed the lower band. The mid-band is thus a potential entry point. A stop order should be placed roughly one-half to two-thirds of the way between the mid-band and the lower band. An exit is placed just above the upper band. 

Apply the same concept to downtrends. The price often tracks the lower Keltner channel line, and pullbacks will often reach the middle band but not exceed the upper Keltner line. The middle line thus provides a short-entry area—a stop is placed just inside the upper Keltner line and a target is below the lower Keltner line. 

On most charting platforms, the default measures for Keltner channels are typically set to use the previous 20 price bars and use an Average True Range (ATR) Multiplier of 2x. The reward relative to risk is usually 1.5x or 2x, meaning for $1 of risk the profit potential is $1.50 to $2.00.

One advantage of this strategy is that an order is waiting at the middle band. Timing the entry is thus not so vague—and once all the orders are placed, the trader does not need to do anything except sit back and wait for either the pre-set stop or target order to be filled.

For more hands-on traders, the strategy can be more actively managed. During a very strong trend, the target can be adjusted to capture more profit. The stop and risk levels should only be reduced as the trade becomes profitable; risk is never increased during a trade.

A disadvantage of this strategy is that it works well in trending markets, but as soon as the trend disappears, losing trades will commence since the price is more likely to move back and forth between the upper and lower channel lines. 

Filtering trades based on the strength of the trend helps in this regard. For example, during an uptrend, if the price failed to make a higher high just before a long entry, avoid the trade, as a deeper pullback is likely to stop out the trade.

Stochastic Oscillator

The stochastic oscillator is another indicator that is useful for trading the most volatile stocks. This strategy works best on range-bound stocks or stocks that lack a well-defined trend. Volatile stocks often settle into a range before deciding which direction to trend next. Since a strong move can create a large negative position quickly, waiting for some confirmation of a reversal is prudent. The stochastic oscillator provides this confirmation.

When the price lacks clear direction and is moving predominantly sideways, sell near the top of the range once the stochastic moves above a level of 80 and then drops back below. Place a stop order just above the high that just formed with a target at 75% of the way down the range. For example, if the range shows a $10 high (from low to high) place a target $2.50 above the low. 

Similarly, take long positions near the bottom of the range when the stochastic drops below 20 and then rallies above it. Place a stop below the recent low and target 75% up the range. If the range is a $10 high the target is placed $2.50 below the high. 

Trades should be taken as soon as the price crosses the stochastic trigger level (i.e., 80 or 20). Do not wait for the price bar to complete; by the time a 1-minute, 2-minute, or 5-minute bar completes, the price could run too far toward the target to make the trade worthwhile. Also, ignore contrary signals while in a trade; allow the target or stop to get hit. Once the target is hit, if the stock continues to range, a signal in the opposite direction will develop shortly after. Figure 3 shows a short trade, followed immediately by a long trade, followed by another short trade.

In the figure above, the range is $0.16 in height ($16 minus $15.84), so 25% of $0.16 would be $0.04. Therefore, deduct $0.04 from the high of its range at $16 to get a target for long positions of $15.96. Similarly, add $0.04 to the low of the range at $15.84 to get a target for short positions at $15.88. While the range is in effect, these are your targets for long and short positions. This way, the target is more likely to get hit even if the price doesn't make it all the way back to the top or bottom of the range when long or short, respectively. 

Consider again the figure above. For the first short trade, just after 1:30 PM, the stochastic rises above 80 and then drops below it. This signals a short trade. Sell at the current price as soon as the indicator crosses below 80 from above. Immediately place a stop above the recent price high that just formed. Set your exit target at $15.88. Do nothing else until either the stop or target is reached. The target is hit less than an hour later, getting you out of the trade with a profit.

The stochastic has since dropped below 20, so as soon as it rallies back above 20, enter a long trade at the current price. Quickly place a stop below the price low that just formed and place a target to exit at $15.96. This trade lasts for about 15 minutes before reaching the target for a profitable trade. Another short trade develops immediately after the prior trade; enter short at the current price as the stochastic crosses below 80, place a stop above the recent price high and place a target to exit at $15.88. The target is reached less than 30 minutes later.

The usefulness of this strategy is that it helps us wait for the price to reach a favorable level, one that is presumably undervalued, even if only temporarily. We can then watch to see if the price will begin to rise from this favorable price level and move in our preferred trade direction before we enter the trade. Therefore, a relatively tight stop can be used, and the reward to risk ratio will typically be 1.5:1 or greater. The main disadvantage is false signals. False signals are when the indicator crosses the 80 line (for shorts) or 20 line (for longs), potentially resulting in losing trades before the profitable move develops.

Since the stochastic moves slower than price, the indicator may also provide a signal too late. When the entry signals occur, the price may have already moved significantly toward the target, thus reducing the profit potential and possibly making the trade not worth taking. Upon entry, the reward should be at least 1.5 times greater than the risk, based on the target and stop.

The Bottom Line

Volatile stocks are attractive to traders because of their quick profit potential. Trending volatile stocks often provide the greatest profit potential, as there is a directional bias to aid the traders in making decisions. Keltner channels are useful in strong trends because the price often only pulls back to the middle band, providing an entry. The downside is that, once the trend ends, losing trades will occur. Monitoring price action and making sure the price is making a higher high and higher low before entering an uptrend trade (lower low and lower high for downtrend trade) will help mitigate this defect.

Volatile stocks don't always trend; they often whip back and forth. During a range, when the stochastic reaches an extreme level (80 or 20) and then reverses back the other way, it indicates the range is continuing and provides a trading opportunity. Monitor both the stochastic and Keltner channels to act on either trending or ranging opportunities. No indicator is perfect, however; always monitor price action to help determine when the market is trending or ranging so the right tool is applied.

Profiting from volatility requires extensive use of technical analysis, including both chart patterns and technical indicators. If you are new to technical analysis or want to brush up on your skills, the Technical Analysis course at the Investopedia Academy provides an in-depth overview of the technical concepts you need to become a successful trader.