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Market Risk and Volatility Risk

By: , dated April 11th, 2013

The first distinction that has to be made between fundamental and technical analysis is that of risks. An investor is most likely to purchase shares of stock as part of a buy-and-hold strategy. This may last years or, for some, only a few months. The selection is based on the company rather than on the price trend in the stock. In comparison, a trader is more likely to focus on the price movement and trend in the stock and is much less interested in the fundamental strength of the company.

So investors focus on financial history and traders focus on current price. In summary, that is the most likely distinction between investors and traders; however, you can combine fundamental and technical analysis to round out your opinions of companies and their stocks, time your entry and exit, and diversify your portfolio. This also diversifies your risks, because the types and degrees of risk for investors and traders are not identical. They are quite different.

Key Point

The basic difference between fundamental and technical is in focus, either on historical financial results, or on anticipating price movement.

Market risk is going to be found in all kinds of markets, even those in which price trends are uncertain. Traders are keenly aware of this and tend to develop strategies to maximize profits in bull markets (characterized by a trend of rising prices) as well as in bear markets (markets where prices are on the decline). Traders believe that by using the right strategies and positioning themselves correctly it is possible to make profits in both kinds of markets. In comparison, those who believe profits are only possible when stock prices are rising (bull markets) by definition have to stay out of the market when they think prices are declining; and that is half the time.

Market risk was explained in the Investment Risks and from a fundamental perspective. A fundamental investor (likely as well to be conservative) has to be aware of price volatility even though the selection criteria include mostly or exclusively a range of fundamental indicators. Most fundamental investors seek stocks of companies with exceptional capital and market strength that are likely to rise in value traders rely on technical indicators (and are more likely to be drawn toward speculation rather than a buy-and-hold strategy), and they understand that price volatility defines risk. So market risk from a fundamental point of view can be clarified and called volatility risk for the technical trader. Traders are likely to recognize the potential for profit in either bull or bear markets, and also are likely to use a range of different strategies that work in both situations.

Volatility risk is specifically related to the breadth of the trading range. This is simply the point spread between the most recent high and low price levels at which a stock has traded. Breadth is relative, however. In a $10 stock, a breadth of two points is considerable; in a $100 stock, it is less volatile simply because the stock’s price is higher. So breadth defines volatility, and the degree of breadth is the price movement in comparison to the price level of the stock.

The trading range can be thought of as a reflection of supply and demand, just as it works in any other market. In real estate, if houses within one neighborhood usually sell for between $135,000 and $150,000, the ‘trading range’ of housing is defined between those high and low prices; and the ‘breadth’ is $15,000. This could also be called a 10 percent breadth, because the price difference between high and low is 10 percent of the high.

In the stock market, breadth and trading range are what define volatility risk. The greater the breadth, the greater the risk. For traders, who are most likely to focus on short-term price movement, higher volatility means greater profit potential in a short period of time. It also means greater volatility risk. For most traders, the most realistic approach is to focus on the stocks with moderate volatility, thus accepting moderate volatility risk in exchange for potential profits. If volatility is too high based on a self-defined risk tolerance, the stock is not appropriate. If volatility is too low, then traders will be equally disinterested because in exchange for low risks, profits are also unlikely.

Key Point

The trading range is the entire framework for technical analysis, and for identifying varying levels of price volatility. Virtually all technical indicators rely on observations of price movement in relation to the trading range.

Trading range, or the price difference between high and low trading in recent sessions, is the most important technical concept to remember. Without identifying a trading range, you cannot interpret current price movement or identify risk levels.

In technical analysis, two terms are essential, as they frame the trading range and give meaning to the current supply and demand for shares of a particular company. These are support and resistance. Support is the lowest price in the trading range, or the lowest level at which sellers and buyers can strike an agreement to exchange shares. Resistance is the highest point in the trading range, or the highest level where price agreement is possible under prevailing conditions.

The concepts of support and resistance define the majority of technical indicators, and traders rely on the structure provided by the trading range (defined as the price breadth existing between support and resistance) to identify strength or weakness of price movement. Most technical indicators involve price ‘tests’ of support or resistance. A breakout below support or above resistance has significance, whether it represents creation of a revised trading range, or fails and price then retreats back to the established trading range. Many indicators involve failed tests of these borders, often preceding price movement in the opposite direction.

Key Point

The borders of the trading range—support and resistance—are the ‘lines in the sand’ that identify success or failure of all short-term price movement.

The trading range, its breadth, and the action between price and the borders of support and resistance are the entire structure of technical analysis. Trading relies on interpretation of price patterns and, specifically, on how price moves within (or breaks out of) the support and resistance borders.

"Adapted from Getting Started in Stock Investing and Trading.
Copyright 2011 by Michael C. Thomsett. All rights reserved. John Wiley & Sons, Inc."
Content provided here under exclusive license
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2014. Content published with author's permission.

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