Stock market volatility is arguably one of the most misunderstood concepts in investing. Simply put, volatility is the range of price change a security experiences over a given period of time. If the price stays relatively stable, the security has low volatility. A highly volatile security is one that hits new highs and lows, moves erratically, and experiences rapid increases and dramatic falls.
Because people tend to experience the pain of loss more acutely than the joy of gain, a volatile stock that moves up as often as it does down may still seem like an unnecessarily risky proposition. However, what seasoned traders know that the average person may not is that market volatility actually provides numerous money-making opportunities for the patient investor. Investing is inherently about risk, but risk works both ways. Each trade carries with it the risk both of failure and of success. Without volatility, there is a lower risk of either.
Volatility and Market Fluctuation
Volatility can benefit investors of any stripe. Many more conservative traders favor a long-term strategy called buy-and-hold, wherein a stock is purchased and then held for an extended period, often many years, to reap the rewards of the company's incremental growth. This strategy is based on the assumption that while there may be fluctuation in the market, it generally produces returns in the long-run. While a highly volatile stock may be a more anxiety-producing choice for this kind of strategy, a small amount of volatility can actually mean greater profits. As the price fluctuates, it provides the opportunity for investors to buy stock in a solid company when the price is very low, and then wait for cumulative growth down the road.
Swing and Short-Term Traders
For short-term traders, volatility is even more crucial. Day traders work with changes that occur second-to-second, minute-to-minute. If there is no price change, there is no profit. Swing traders work with a slightly longer time frame, usually days or weeks, but market volatility is still the cornerstone of their strategy. As price seesaws back and forth, short-term traders can use chart patterns and other technical indicators to help time the highs and lows. Using indicators such as Bollinger Bands, a relative strength index, volume, and established support and resistance levels, swing traders can pick out potential reversal points as price oscillates. This means they can go long on the stock, or buy calls, as price nears a low and then ride the upswing to sell at or near the high.
Similarly, predicting when a volatile stock is exhausting its current bullish momentum can mean shorting the stock, or selling puts, just as the downturn begins. These types of short-term trades may produce smaller profits individually, but a highly volatile stock can provide almost infinite opportunities to trade the swing. Numerous lesser payoffs in a short period of time may well end up being more lucrative than one large cash-out after several years of waiting. (For related reading, see "How to Bet on Volatility When the VXX Expires")