Understanding Volatility — And How To Use It To Your Advantage

If you take a finance class, watch the talking heads on cable news, or browse through academic papers on investing, you’ll quickly be inundated with the concept that “volatility” is synonymous with “risk.”

In just about every instance, the stated assumption is that volatility is “bad” and should be avoided at all costs.

As is often the case, there can be a wide chasm between the academics and the actual “boots on the ground” experience. Today, we’re going to travel just a bit off the reservation and discuss why volatility is not the same thing as risk. In fact, we’ll explain why we as traders actually need volatility to generate healthy returns.

The Volatility/Risk Assumption Is A Cop-out

One of the reasons financial literature equates volatility with risk is because volatility can be easily measured. Any statistician can take a series of data points and tell you which stock has wilder swings. He can even tell you which portfolio manager has more ups and downs than his peers. But does that really measure the amount of risk inherent for the stock? Or how talented the manager is at protecting his capital?

Let’s assume there is a drug company with a stable base of revenue that just received a contract to market drugs to an entirely new customer base across South America. The stock would likely jump wildly on the news, sending volatility sky-high.

Then, assume that the management team adds a correction that the contract actually won’t be put into place until midway through next year. Short-term traders get frustrated (they wanted to see earnings double this year) and sell shares, and the stock drops back almost to where it was trading before the first announcement.

According to the financial models, this stock would be deemed much riskier than a “steady Eddie” competitor. Even though our company has huge growth potential and an existing customer base that is still paying for its current line of products. This is just one example of how volatility really doesn’t equate with risk.

We can also run down a list of hedge fund managers who had nearly zero volatility (Long Term Capital Management, Madoff, etc.) and still wound up being some of the riskiest investments available. And there are plenty of very talented managers who embrace volatility and generate profits while still being careful to protect the initial capital.

The Truth About Volatility

Taking an objective look at volatility, there are basically two reasons why volatile pricing swings occur:

1. Volatility exists because there are differing opinions on where prices should be.

2. Volatility exists because the real world continues to change.

When investors and traders disagree on what the value of a stock (or any other asset) should be, they vote with their money. If you think that a stock is too cheap, you buy it. If you think that it’s too expensive, you sell it.

The market price represents the equilibrium between the sellers and buyers. As buyers and sellers become more convinced in their perspectives, they push harder and harder — thus driving stock prices higher or lower.

Also, let’s not forget that we live in the real world (something academics all-too-often overlook). In the real world, things change. People decide to buy products or not to buy them. Companies hire or fire. Accidents happen and new opportunities arise. As the world turns and situations change, the value (and by extension, the prices) of assets continually shift.

Okay, that’s enough academics for one day. Let’s dive into how we actually make money from volatility.

Volatility And Options Pricing

Without getting into too many of the boring statistical details, you may already know that option prices are directly tied to the volatility of the underlying stock. The more volatile the stock, the higher the price traders must pay for contracts.

Historically speaking, the more negative the price action, the higher the volatility. This is because negative price action increases fear. You can see this reflected in the CBOE Volatility Index (VIX) in the chart below…

You can also see it if you look at a weekly chart of the broader market going as far back back as 100 years. When markets are healthy, prices climb in a relatively steady manner. Sure, there are some dips and a bit of back-and-forth. But for the most part, prices rise in a non-volatile manner.

However, when stock markets drop, they often drop suddenly and swiftly. This is because investors panic at the wrong times and sell out of positions regardless of the price. That sends stocks plummeting — and volatility skyrocketing.

You can’t see it on a stock market chart, but when stocks drop sharply, the price of options contracts increase sharply. We traders call it the “fear premium” moving into the market.

Action To Take

This “fear premium” is important for options traders. During times of turbulence, our potential for great returns can go up dramatically — not down. (Remember what we said about volatility not being the same as risk?)

As stock prices become more volatile, option values rise. So, for example, during times of stress we could use that to our advantage by buying a stock we like for a cheaper price. We could then hedge our risk more effectively by selling a covered call contract for a higher premium that puts more money in our pockets, thereby taking on less risk.

This is just one example. (Put sellers, for example, would earn a higher premium from their trades, too.)

This concept is important for you to understand now, because whenever volatility rears its head again, you need to be ready. If you start to see volatility picking back up again, the typical buy-and-hold investor will become uncomfortable with the swings in their net worth. And many of them will see a dramatic decrease in the value of their accounts as stock prices drop.

But for traders, especially options traders, the opportunity will increase as we harness the power of volatility and use it to our advantage.

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