Stock Price Volatility Is an Opportunity, Not a Problem

Stock market volatility is inevitable. No stock goes straight up or straight down for very long. There will be seemingly irrational movement within every trend, and it will consistently trigger stops no matter how carefully you set them. Volatility can be your worst enemy or your best friend, depending on how you handle it.

As an investment advisor, I have learned that some clients are willing to sacrifice higher returns for lower volatility. Volatility causes stress, and most people prefer to see a nice steady increase in their portfolios rather than wild fluctuation, even if there ultimately is a higher return. The more risk you take, the more volatility you are likely to encounter.

The primary problem with volatility is that it evokes an emotional response. When a stock suddenly makes a big move, the natural tendency is to look for an explanation, and when you can’t find one, you assume that someone knows something that you don’t.

The vast majority of the time, the daily movement of a stock has little to do with its fundamentals or valuation. Market conditions, along with membership in ETFs and indices, will cause the most volatility, but since we have no way of determining if something has changed fundamentally, we will assume that we have made a mistake.

Volatility varies widely by stock. A statistical measure called "beta" can show how volatile a stock is compared to an index. For example, Apple AAPL has an average monthly beta over the last five years of 1.24 compared to the S&P500. It moves roughly 25% more than the index.

Small caps will have much higher betas. For example, Palantir Technologies PLTR has a beta of 2.7, which means it moves nearly three times faster than the indices in both directions.

It is extremely important to adjust your trading depending on the level of beta. If you try to trade Palantir in the same manner that you trade Apple, you are very likely to have suboptimal results, especially if you are trying to set stops to control risk.

Good traders tend to develop a tolerance for volatility. They know that positions will move around randomly and take that in stride. It can be discouraging when there is a sudden drop, but if the stock selection is good and market conditions are favorable, it is a good idea not to overreact. My best positions are almost always the ones that have the most significant short-term losses.

The more volatile a stock is, the more opportunity there is for some good trades. In the short term, a stock that moves three times more than the indices will offer plenty of room for very short-term traders to make money.

I focus primarily on smaller stocks with high levels of volatility. This can create big swings in my portfolio, but I deal with it by using the volatility to vary my position size. When volatility is in my favor, I reduce my holdings and look to add to my positions when downside volatility creates opportunities. I tinker with position size almost daily in some stocks as I try to build larger positions at the right time.

One of my main goals in building positions is to always feel like a downside move is an opportunity rather than a problem. If nothing has changed fundamentally and market conditions are driving the action, then I want to be able to take advantage of weaknesses. To do that, I have to constantly look for opportunities to reduce my position when it seems like it may have limited near-term upside.

Volatility can drive you crazy if you don’t anticipate and plan for it. However, it is inevitable, and it can significantly enhance your returns if you plan for it in your trading or investing methodology.

At the time of publication, DePorre was long PLTR.