Wednesday, March 21, 2007
Volatility is not a Dirty Word
Another approach to the sharemarket is the short term trading approach. Traders monitor prices and actively buy and sell shares to profit from short term market movements.
As we have seen, this type of investing has been made accessible to the ordinary individual thanks to the Internet and the availability of share charting software for the personal computer.
Being an active trader requires putting in a day to day effort, but isn't really that difficult and can provide much greater returns.
For example, look at this chart of Telstra ordinary shares throughout 2006...
Telstra opened on the first trading day of the year at $3.94, and closed on the last trading day at $4.14. If you were holding this share you would've made 20 cents per share for the year or just over 5%.
But what we're seeing here is not a nice predictable rise from $3.94 to $4.14 - the share price jumps up and down all over the place! That's what we call volatility, and it's the key to the short term trader's profits.
Suppose instead of holding the share throughout the year, we had bought it every time it fell to $3.65, and sold it every time it went to $3.90...
In each buy and sell transaction, or trade, we make 25 cents per share or 6.8%
And lo and behold, this happens not once but four times throughout the year. That's a return on our investment of 4 times 6.8 equals over 27% for the year! - Even without allowing for the effects of compounding (reinvesting the profits).
Of course this is a contrived example - we wouldn't have known Telstra was going to cross those particular levels again and again. But it highlights the potential profits locked away in short term price changes thanks to the volatility of the sharemarket.
Techniques exist to identify these short term trend changes as they happen - a field called technical analysis. By learning these skills, the short term trader has access to profits denied to the long term investor.