Thursday, May 1, 2008

Can Volatility Kill?

People who trade options study volatility closely. They hunt it out or avoid it. They massage it and time it. They know it can work for them, or against them, and in either case it strongly affects their price.

In contrast to the option trader, most of us stock investors give volatility very little thought, if any.

If that's you, you can continue to trundle happily down that path, ignoring the whole issue. if you stick with blue chips and plan to hold them for 20 years, that is.

Otherwise, it would be worth your while to give the subject a little notice. A great deal of what the experts tell you about stocks and how to handle them is closely linked to their beliefs about volatility and their reactions to it.

But on the more practical level, volatility may also affect whether you are profitable, what kind of stocks you should buy and how you handle your money.

As with the series on trend lines, I am going to break this subject down into rational pieces. You will find that the subject is not abstract at all, and is certainly not as complex as some people would have you think.

Normally, a discussion of volatility in stocks heads right to the deep waters of Modern Portfolio Theory, beta and academic studies. We'll get there, but we'll start at the commonsense end of the subject, before academics chop it up and give each of its parts ten-dollar names.

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