- May 14, 2023
- Posted by: Parker Evans, CFA, CFP
- Categories: Myths, Portfolio Management, Stocks
Momentum and Volatility: What Goes Up Must Come Down?
Hello, fellow investors and aspiring traders! Today we will explain how stock price momentum and volatility are related and why you should care about them. You’ve probably heard the adage, “What goes up must come down,” right? Well, it turns out that this applies to stocks as well. Let me show you how.
Momentum measures how fast and far a stock’s price moves in one direction. It’s like a rocket 🚀 that accelerates as it goes higher. Momentum traders look for stocks that are rising rapidly and jump on board, hoping to ride the wave end until it reverses. Sounds fun, right?
Volatility measures how much a stock’s price fluctuates around an average level or range. It’s like a roller coaster that goes up and down, sometimes violently. Some traders look for stocks making unusual wide moves and bet on the swings, hoping to profit from the ups and downs. Sounds exciting, right?
But here’s the catch: momentum and volatility are two sides of the same coin. They both reflect the degree of uncertainty and risk in the market. A stock with high momentum also has high volatility because it can reverse direction at any time. And when a stock has high volatility, it also has high momentum, because it can break out of its range at any time.
So, what does this mean for you? It means you must be careful when trading stocks with high momentum and volatility. They can offer huge rewards but also huge risks. You need a clear strategy, a good entry and exit plan, and a strong stomach. Easier said than done.
One of the biggest challenges of trading momentum and volatility stocks is dealing with cognitive biases. These are mental shortcuts that can lead us astray when making decisions. For example:
- Confirmation bias: we tend to look for information that confirms our beliefs and ignore information that contradicts them. This can make us overconfident in our trades and blind to warning signs.
- Recency bias: we tend to give more weight to recent events than older ones. This can make us chase after hot stocks that have already peaked and avoid cold stocks that have already bottomed.
- Anchoring bias: we tend to rely too much on the first piece of information we receive. This can make us stick to our initial price targets and miss opportunities to adjust them based on new information.
To overcome these biases, we need to be aware of them and use objective tools and indicators to guide our trading decisions. For example:
- Relative strength screens: these screens compare the performance of a stock to other stocks or to the overall market. Screeners can help us find stocks with strong momentum and avoid weak ones.
- Bollinger bands: these bands chart plus and minus two times the standard deviation of price around a moving average. They help us measure volatility and spot potential breakouts or reversals.
Using these tools and others, you might trade momentum and volatility stocks more effectively and avoid falling prey to cognitive biases. But…
To mix metaphors, active trading is like a treadmill: you sweat a lot, pay a lot, and don’t get anywhere. At Successful Portfolios, we believe long-term investing is more like a hammock: you can relax, enjoy yourself, and watch your money grow. Why run when you can swing?
Remember: what goes up must come down, but what goes down can also go up again! Trading is harder than it looks.
We hope you enjoyed this blog post and learned something new. Happy long-term investing!