The hardest part of trading and investing isn't finding a good stock to buy. The hardest part is navigating the inevitable volatility that will occur after you buy it. There is a direct correlation between volatility and returns. The best-performing stocks tend to be the most volatile. The ones that move the most will move in both directions. It is easy to find stocks with low levels of volatility but they are very seldom big winners.
If you want to own the big winners then you better be ready to stomach some big swings along the way. Even great long-term stocks like Apple (AAPL) and Microsoft (MSFT) have dropped by 40%-50% or more in their travels over many years.
The problem with volatility is that it evokes strong emotions and strong emotions lead to poor decisions. When a stock is swinging around randomly we can't help but wonder whether we made a mistake in picking it in the first place or whether we just aren't very good at trading it.
The biggest mistake I see new traders make is to try to find an explanation for every minor movement in a stock and to overreact as it jumps around. When a stock doesn't go straight up there is an inclination to believe there must be something wrong since it is obviously is such a great stock pick. Why isn't the market doing what it should be doing? We must be wrong and should just dump this stock and move on to something else.
The upside of volatility is that it offers tremendous opportunities. When a stock pulls back for reasons that have nothing to do with fundamentals or valuation, it produces some of the best opportunities that a trader can find. I suspect that the majority of my returns over the years have come from trading the volatility in a stock after I initially buy it rather than from simply holding the position.
Trading volatility is a topic that requires an entire book but the first step in dealing with volatility is developing a tolerance for it. We need to find ways to exploit volatility rather than fear it.
It is not easy to do, but simply increasing your tolerance for volatility is often the best way to improve trading results. If you sit in front of your computer screen and watch ever tick then you are going to react to even minor moves. If you are day trading or trading in very short time frames then that is the goal but if you pursuing position trades or trend trades then you must take volatility in stride.
Most market players just do not have sufficient tolerance for volatility. Even those with well-defined trading plans can't resist the temptation to react when a stock makes a sizable move. We are prone to either panic sell or to average down and increase risk levels too much. Those emotional reactions lead to even strong emotions and that is when major mistakes occur
The best way to develop a tolerance for volatility is to not hold positions that are too big and not watch stock movement too closely. I find that holding many different positions is a good way to do this. When I'm holding 30 or 40 positions, I don't have time to react to minor movements, and my risk in any one stock is low so I can handle some sizable swings.
The dilemma is that we want to go big when we have a winner and that is when we can use volatility to help us. When a favorite position pulls back and sets up that is our opportunity to trade it much bigger in multiple time frames. I might buy a sizable position on a pullback with the view of a day trade or very short term trade. I'll sell into positive volatility and buy on downside volatility. The key is to have a plan and stay strategic and you can do that much better if you anticipate volatility rather than dread it.
The most difficult question about volatility is when does it reach a level that it changes the conditions of the overall trade. It is very tough because even a stock like Apple can fall 40% or so within a much larger uptrend. This is where developing a trading methodology of selling and rebuying to control risk comes into play. I've discusses that in-depth elsewhere. Temporary selling to control risk is a tremendous tool for dealing with the problem of major price moves.
Volatility is inevitable and it is foolish to just sit and hope it will go away. Our best stocks are going to swing around randomly at times. We need to embrace that fact and find ways to deal with it logically rather than emotionally.
(Apple and Microsoft are holdings in Jim Cramer'sAction Alerts PLUS member club. Want to be alerted before Jim Cramer buys or sells these stocks?Learn more now.)
