It likely won’t surprise you to hear that an old-line, blue-chip stock like American Express (NYSE; ticker: AXP) is less volatile than a small-cap gold mining stock like Yamana Gold (NYSE; ticker: AUY).
But do you know by how much?
That’s the key to becoming a successful investor in the stock market.
At TradeStops we’ve developed a number that makes it easy to understand a stock’s normal volatility. We call this number the “Volatility Quotient,” or VQ for short. The VQ represents the normal volatility one can expect over a 12-36 month timeframe.
(What is volatility?… It’s a way to measure the change in the price of an investment over a particular period of time. Whether stocks are going up or down, the amount they move either way is the stock’s volatility.)
The VQ can be used to understand the volatility of a single stock and it can be used to compare the volatility of different stocks. An example that we use often is comparing a stock with a low VQ percent to a stock with a high VQ percent.
We mentioned AXP above. The VQ of AXP is 13.89 percent. That means the normal “noise” in AXP is 13.89 percent.
If you buy AXP, you’d want to set up a trailing stop-loss of 13.89 percent. Why? Because that’s the normal volatility of AXP. A healthy stock stays within its normal range of volatility. If AXP were to move against you by more than 13.89 percent, then that tells you the stock is no longer in a healthy state and you’d want to exit the position.
Now, let’s compare this to the gold mining stock AUY. It’s a more volatile stock than AXP. Any guess as to how much more volatile?
AUY is almost four times more volatile than AXP!
With a VQ of 50.56 percent, you have to be prepared for AUY to move against you by 50 percent and still be within its normal range of volatility.
What is the Takeaway Here?
Let’s assume that you normally use a 25 percent trailing stop. If you invest in AXP, then you’re letting the stock run almost double its normal volatility before it hits your stop. This could really damage your portfolio.
On the other hand, if you use a 25 percent trailing stop for AUY, you risk stopping out while the stock continues to trade within its normal range of volatility and negate the potential upside of stocks with high VQs. This could limit the potential profitability of your portfolio.
One of the important decisions for you as an individual investor is to determine how much risk you’re willing to take in any stock. If you make the decision that you’re not willing to take on too much risk, the VQ can help you with your investments.
Let’s assume that you have made the decision not to take on more than 20 percent risk in any one position. By knowing that the normal volatility of AUY is more than 50 percent, it’s easy to make the decision to not invest in AUY as its volatility is more than double what you’re willing to risk.
Knowing the VQ can also help you make smart decisions on how much to invest in each stock.
Let’s say that you’re willing to invest with US$1,000 of risk in each stock in your portfolio. Using this type of “risk parity” is another key to outperforming the markets over the long run.
If we want to invest US$1,000 of risk in AXP, we take US$1,000 and divide that by the VQ. 1,000/.1389 = 7199.42. In other words, we can invest almost US$7,200 in AXP and we’ll have US$1,000 of normal risk.
To invest with US$1,000 risk in AUY, we perform the same calculation – 1,000/.5056 = 1,977.85. We’d invest less than US$2,000 in AUY to take the same US$1,000 risk that we’d take by investing US$7,200 in AXP.
See how easy that is?
By knowing the VQ of any stock, fund, or even a cryptocurrency, you’ll know its normal volatility. Know the VQ and you’re on your way to becoming a very successful investor.
*This has been a guest post by Stansberry Churchouse Research*