By Tim Dooling
Ever notice how people love to use the word “Volatility?” Often used in conjunction with a greek letter or two in an effort to dazzle the recipient into a state of awed confusion. The reality is that the word “Volatility” means very little by itself, and in my experience 90% of the people who use the word could not stop and define what they mean by volatility in any meaningful way.
Common foibles :
“This is a volatile market” correctly stated is “I measured the last few day’s price changes and they are larger than the others I generally experience.”
“Volatility is killing me…” what they mean to say is “I react poorly to uncertainty.”
“Should I sell this thing?” actually means “I am in a weak position and am being impacted by emotion, can you please take my money?”
Conceptually Speaking.
Volatility is a concept conceived by humans to measure and describe uncertainty and quantify how different something is from our expectations. It can also be used to describe the path a series takes between
two points.
It is not a commodity or any kind of tangible thing, although specific types of volatility can be calculated with precision and traded, and actual historical volatility encountered is perfectly calculable.
In fact all types and descriptions of volatility can be calculated, what makes the world go around is the
difference in two party’s perceptions of volatility and different implications of volatility in different situations.
These differences in perception and value give rise to transactions.
A measure of volatility is implicit in every conceivable price of every financial instrument that exists; people understand volatility except when they are confronted with it by someone who is intent on confusing them. Anyone operating in an economy deals with volatility daily. From a grandmother with a checking account to the guy in the funny jacket trading futures, everyone understands volatility because they price it constantly by the actions they take. The concept is very understandable, however describing and measuring it can make it sound confusing.
Whether they realize it or not, any rational person with complete information who sells a security is implicitly making the declaration that “I believe there is more uncertainty around the expectation of future price than this price will reward me for.” This is the essence of it all; there may be uncertainty around the future profitability of a business, or uncertainty around the shareholders ability to sell it in the future.
Any element of uncertainty that drives a buy/sell decision at it’s core it can be referred to as volatility.
Practically Speaking
Practitioners realize the time-dependency of any volatility measurement and a lexicon has developed which takes the generic term and makes it meaningful in a particular situation. Things like “S&P 30 day Implied Volatility” (aka the “VIX”) or “the October IBM volatility smile” or the dazzling “Volatility Surface” each refer to a number (or series) that can be observed, calculated and traded. What makes it interesting is when two peoples views of the future are different, which gives rise to a transaction between them.
Wikipedia calls volatility: “a measure for variation of price of a financial instrument over time.” Sounds easy enough, but what if I told grandma that volatility was “The standard deviation of returns times the square root of time.” She might get confused about what really is a simple concept. She might even empty her checking account and go dig a hole somewhere.
Play Easy Games
Stocks go up and down, that is what they do, it is part of what makes a stock a stock. Uncertainty is inherent in their nature, so why is there an entire edifice of sophisticated industry aimed at predicting the next tick of a randomly changing price? The answer is because it is easy for financial people to profit from the fear/ignorance of the public.
Consider the frisky New Yorker walks in and says “You gotta buy this piece of paper I’m selling because it’s a theta-neutral Vega-grazer.” This is doublespeak for “I will get paid if I can make you think I found the Holy Grail.” The concept of volatility lends itself particularly well to feed the beast of the financial edifice, because it makes the game easier for the predator.
The reality we encounter every day requires us to deal with many levels of uncertainty.
Thankfully our evolutionary success has given us many tools to deal with it with relative ease.
Without a smartypants financial guru to confuse us with the paralytic analysis about all the possible consequences of getting out of bed in the morning, we still do it every day.
If you owned every stock on the planet and held them for an infinite time frame, you are more than 99.9% certain to enjoy a positive outcome. Contrarily, if you buy one stock and hold it for a nanosecond you are nearly certain to lose money, and even if there was no fees/commissions/spreads to deal with, you are still looking at even money in a best case scenario….. which would you rather do?
So when stock markets get volatile people tend to seek advice of someone they think will provide them with an answer they want to hear. Too often the prey (the investor) will seek the advice of the predator (the broker). This rarely results in a wealthier investor.
Oh the humanity:
We cannot put the blame on volatility for harming us. It is not the volatility that hurts, it is our reaction to it that causes the pain. The good news is that ever since Adam ate the apple, there have been people around who are more than willing to pander to our fear and greed.
Sounds like a job for the ETF creators:
Volatility is a multidimensional concept the most important of which is time. No security has one number that defines it’s volatility, any definition must specify the time interval over which it will be measured or forecast. Futures do a decent job of standardizing this, with VIX futures contracts available for each month of the year. But that is only half the story. The underlying deliverable of the monthly VIX future is the 30 day implied volatility of the S&P 500. The trouble is that the stuff that the VIX is calculated from changes every day, and the stuff that the VIX future is calculated from changes only once a monthAnother way to think about it is that at the expiry of a VIX future, the holder will receive the value of $1000 multiplied by the weighted average of the next 30 day implied volatility of the S&P 500. So on the last day of trading for any particular contract looks forward another 30 days and derives it’s value from 1 month forward expectations of volatility levels.
The point is that tracking the VIX index is a cumbersome and potentially costly thing to accomplish. So the good folks at the ETF companies have created products which do all this logistics for you. The only problem is that they make very sure that they are well compensated for doing it. They are playing the easy game.
Over a year, or a day (the two graphs below) take your pick, you will not get what you think you are, in fact you will miss rather dramatically.
1 Year VIX (Blue Line) and S&P 500 VIX Short-Term Futures ETN (Green Line)
1 Day price change for same two series:
It is a pretty common misconception that the VXX and other “Volatility Index Related” ETN’s actually track the VIX. The companies which create these products do not go out of their way to clear up this subtlety. In fact the names they give the funds are a case study in vaguery. If the truth be told, despite the name “VIX Short Term Futures”, it is not intended to track the common VIX index, instead it is designed to have a “constant maturity” of 30 days, which accounts for much of the discrepancy in the graphs above.
It’s the difference that matters:
The message of this note is not the volatility that matters at all, it is the difference between our individual reactions to it and how we value certainty that is important.
Suppose some dapper gent calls and says “Of course volatility is important because it is what determines my ability to hedge and manage risk.” My response would be “No it doesn’t”. The reason is that if someone has a particular tolerance for (or view of) the path that an asset price is likely to take they can take advantage of that view, or remain within their tolerances if someone else has a different view or tolerance, that is what makes a market a market. If your livelihood depends on certain outcomes, then you should buy lots of insurance. If you have low liquidity requirements and a long-term horizon, you should sell lots of insurance.
How to do it you ask? In a financial context insurance takes many forms, options, futures, swaps all are essentially insurance products, yet nearly all of them can be replicated by buying/selling some changing fraction of the underlying , except one…..
Ye Olde Variance Swap
The good folks in academia devised an incredibly useful mechanism for trading expectations of uncertainty called a Variance Swap, the only problem being that they took it to Wall Street to price it. A Variance Swap is a confusing thing so I’m going to punt on any explanation of it to the good folks here: http://www.ivolatility.com/doc/VarianceSwaps.pdf. (but brush up on your greek before attempting it)
Suffice to say that a Variance Swap is simply that it is a mechanism for people to price their views/tolerances of volatility. Think about it as an insurance product where the thing you are insuring is an intangible concept that exists in a parallel (Vega) universe (Variance).
The point is that mechanisms exist to transfer exposure to uncertainty, so instead of worrying about it, my advice is to understand how much of it you want to have and be content with it. Do not let some Wall Street Jabberwocky sell you the Holy Grail, because take it from me, he does not have it……If he did it would not be for sale.
