Cash in on volatile markets

Stockmarkets are highly volatile at the moment because the two big drivers of sentiment are working in opposite directions.

While panic around peripheral eurozone debt levels has seized centre stage, a widespread belief that economies worldwide are slowly but steadfastly recovering remains in the background, preventing Armageddon.

When markets are being pulled in two directions like this they tend to leap around and overreact on the downside.

This creates opportunities for investors prepared to study the price patterns of the more volatile shares and implement a strategy of repeatedly buying near the bottom of their price ranges and selling at the top.

It is not dissimilar from the day-trading strategies of the late 1990s, except back then share prices moved in one direction - a rising tide that lifted all boats.

In the current market shares move around sharply and fall as often as they climb, so it is sensible to stick with large shares that are liquid and can be sold easily.

This will be crucial if, as asset managers such as F&C Asset Management predict, global stockmarkets don't stop falling until 'outright capitulation' marks a turning point in investor sentiment.

What we're looking for are shares that fluctuate violently, and one indicator of such volatility is a share's beta, calculated using historic price data.

A beta greater than one indicates that a share's price will be more volatile than the market. For example, if a share's beta is 1.2 it's theoretically 20% more volatile than its peers.

Volatile stocks

Looking at the most volatile FTSE All-Share stocks with a market cap of £100 million or more in terms of their beta, the group is overweighed with miners and banks, but it also includes the housing and construction groups Taylor Wimpey and Barratt Developments as well as pharmaceutical, media and support services companies.

By studying the price movement of a handful of these shares, getting to know their businesses, and identifying the factors that historically move their prices, it is not difficult to spot when they drop too far against the trend.

Bollinger bands can help determine a stock's trading range. Stock charts showing Bollinger bands are available free from Interactive Investor ( in the Trading Tools section.

A Bollinger band chart will show two lines, one either side of a central share price line, like two outriders keeping an eye on the price. When the price hits the top Bollinger band it's overbought; when it hits the bottom band it's oversold.

The idea is to spot when the share price hits the lower band because the share will often then bounce sharply.

Adding the 200-day moving average to the chart clarifies the picture, strengthening the buy signal if it, too, nudges the lower Bollinger band.

Bollinger bands can provide a good buy signal for traders and long-term investors looking to enter the market.

The Anglo American charts show that the price line touched the lower Bollinger band in early May and then swiftly recovered, giving an emphatic signal to buy at 2,600p, before the shares then retraced to 2,750p.

Looking back at the miners' performance over the past year, the price line hit the lower Bollinger band on four other occasions when bigger profits were up for grabs.

Wide Bollinger bands generally indicate high volatility, while narrow bands indicate a change in trend.

The best stocks to buy are those where the bands veer repeatedly between wide and narrow, as this means buyers and sellers disagree about the share price, which will consequently seesaw.

The more the share fluctuates, the greater the number of chances to buy on a bounce.

The chart of Enterprise Inns shows wide/narrow/wide Bollinger band patterns: tightly converging Bollinger bands herald a major directional change in share price and normally, as in July 2009 or January 2010, they signal a big rise.


One side-effect of current volatility is that stop-loss tools sometimes shut investors out of their positions just as share prices rally strongly. Stop losses automatically initiate a sell order on a stock if the price falls below a specified level.

Investors can instead put on trailing losses - set at a percentage of the market price of the stock - which follow it up and down.

Another way to profit from market volatility is via traded options and selling calls against shares you own. You effectively sell another investor the right to buy 100 specific shares at a set specific price.

In return you receive a non-returnable cash premium upfront. The exercise price is usually set at or above the current level, and if the price remains near its current level the options expire as worthless.

A covered call strategy therefore provides an element of downside protection in a bear market and may generate premiums in a non-trending market. However, investors can lose out if markets as a whole march higher.

The more volatile the share the higher the call premium is likely to be. In normal times a good yardstick is around 3-5% of the stock's value, but some options are now priced at two or three times their price last year.

Not everyone has an options account, of course, but some simple exchange traded funds track covered-call indices.

Covered-call ETFs often pay a juicy dividend yield derived from their underlying long positions and the call-writing premia, and suit investors seeking to reduce their volatility and boost income.  

This article was originally published in Money Observer - Moneywise's sister publication - in July 2010

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