Let’s say you decide to deposit $100,000 into a brokerage account. You decide you will check your virtual portfolio on a weekly basis. Now let’s further assume that the first week has passed and you are about to log in to your account. But before you do, you are told that one of two things has happened in the past week.
[1] Your virtual portfolio went up $10,000 and then dropped $10,000
[2] Your virtual portfolio went up 10% and then dropped 10%.
So, the trivia question is: In case [1], what should you expect your account value to be and is that the same figure as in case [2]?
If you answered $100,000 in case [1], you would be absolutely correct! If you answered that this is the same as in case [2] you would be absolutely incorrect! Why? Well let’s take a look at what happens when the virtual portfolio rises 10% first; it goes from $100,000 to $110,000. But then we’re told it drops 10%. 10% of $110,000 is $11,000. So the virtual portfolio drops from $110,000 to $99,000.
Now how can this help us in our trading decisions? In its simplest form, this tells us that if we were to simply buy stocks that over the long run had a tendency to rise up substantially and fall down substantially ie starting at 0% and rising up and ultimately falling back to 0%, the volatility is impacting long-term returns. In statistics, that percentage swing would denote variance, which in turn is often equated with risk. Another term for risk is beta. High beta stocks tend to move more than the market and tend to have greater variance.
So, if you are in the market for the long-term, you should certainly pay close attention to the impact of variance. Over time the impact to the $100,000 virtual portfolio is not just a drop of $1,000 as in the period shown above, but that virtual portfolio erosion continues over time to the detriment of overall wealth. Unless….
Unless, you know how to take advantage of such volatility. Buying and holding stocks is about as advanced a trading technique in this day and age as owning a cell phone that simply operates as a phone. Why accept bare functionality when you can combine the basics with so much more. In the stock market, this means using options. (In cell phones we already know they come with email, calculators, personal organizers, GPS etc).
Phil, Opt, fellow PSW members and partners at Stock and Option Trades are all here to help. Take advantage and learn how to use volatility to your advantage!
