Volatility

Introduction

You’ve probably heard the old business school joke about the shopkeeper who sold all of his products at a loss – but tried to make up for it in volume. An equally colorful tale is the  option trader who overpaid for his calls and puts but tried to make up for it through strategies, fundamental or technical analysis, Fibonacci Sequences, Elliott and Kondratiev Waves, Kelly Betting Systems, and stock screening software.

Neither approach works for making money.

The fatal flaw for the shopkeeper is a partial understanding of the connection between revenues and expenses. By selling at very low prices, he’s certain to increase his revenues dramatically. Unfortunately, that’s the only part of the story he understood. By overpaying for his inventory though, it’s obvious that he will never make up for the costs no matter how much he sells. Bigger volume just creates bigger losses. Any strategy to make up for it is, well, a joke.

Option traders, like business owners, have a similar relationship they must understand but the connection is not so obvious as revenues and costs. Unfortunately, it’s always easy to overlook what you cannot see. The invisible force responsible for the majority of all option losses is called volatility. If you overlook volatility – or miscalculate it – you may multiply your losses faster than the shopkeeper selling below costs. And that, of course, is no laughing matter. So what exactly is volatility?

The dictionary defines volatility as instability, unpredictability, or explosive in nature. You’re probably more familiar with volatility being associated with emotions, volcanoes, chemicals, or even the temper of Homer Simpson when he discovers another employee snatched the last pink doughnut.

When we talk about volatility in the stock market, it means the same thing; the only difference is that we’re talking about the unpredictable or erratic nature of prices. Stock prices are up, they’re down, they move all around; they’re soaring, they’re boring, then they fall to the ground. Sometimes the swings are insignificantly small; other times they are unimaginably extreme. That’s volatility.

Mathematicians have come up with a way to measure and record volatility with a single number much like they can measure the “size” of earthquakes. Volatility measures the stock’s “price activity” must like the Richter scale measures seismic activity for earthquakes.

The greater the gap between the stock’s high and low prices, the bigger the volatility – and the more valuable is the option. It is stock price volatility that gives an option its value. The more volatile the stock’s price, the more expensive is the option. Okay, so the secret to making money with options is to buy them with low volatility and sell them with high volatility, right?

Wrong!

The reason is that the only volatility number that matters is the volatility that will exist over the life of the option. While we can observe past volatility, also called historic volatility, it is only the future volatility that matters. And unless you have a highly polished Swarovski crystal ball then that is something you cannot know today. While we can certainly estimate the future volatility, it is more complicated than that.

Volatility not only depends on what the crowd thinks, it depends on what the crowd thinks the crowd thinks. (I did warn you it was complicated.) In order to understand why, we need to consider at an unlikely starting point – how to judge a beauty pageant. Understanding is the key to unlocking the secret to an option’s value.

The Economics of Beauty Pageants   
In 1936, renowned British economist John Maynard Keynes explained price fluctuations in his masterwork, General Theory of Employment, Interest, and Money. There he drew the analogy that traders in a financial market make decisions much like participants of a beauty contest run by a local London paper at that time. The paper would run 100 photographs of women considered to be the most beautiful. Readers were asked to choose a set of six faces and everyone who picked the most popular face won a prize.

If you wanted to participate, it may seem that you should look through the photos and pick the six faces you think are the prettiest. However, a better “judge” wishing to win the contest will use no such strategy. 

Instead, the reader will choose the six faces he suspects will be considered the prettiest by the majority of the people. But why stop there? A more sophisticated judge will take this reasoning into account and attempt to second guess the other judges’ second guessing…and so on and so on. Each level attempts to predict the selections based on the reasoning of other judges.

As Keynes stated, "It is not a case of choosing those [faces] which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what the average opinion expects the average opinion to be." 

Keynes would have believed a similar process creates volatility in the stock market. Traders do not price shares based on their fundamental or technical views but, instead, on what they think everyone else thinks the future share prices will be. Asset valuation is a constantly moving target and that’s why prices can be so volatile.

This poses another problem for option traders. As suggested by Keynes, in order to succeed at options trading, you must be good at “mob psychology,” which is a never-ending cycle of second-guessing the second-guesser. That’s difficult.

However, options traders have a second, simpler choice. Volatility has many properties that must hold over time. By using a tool called volatility cones, or volcones for short, we can estimate whether volatility is at a relative low or high. That’s easy. Once that information is established, it is easy to determine whether an option is truly cheap or expensive. It is the only fair way to judge prices.

American inventor Richard Buckminster Fuller once said, "When I'm working on a problem, I never think about beauty. I think only how to solve the problem. But when I have finished, if the solution is not beautiful, I know it is wrong.”

Yes, volatility poses a problem for options traders. Volatility cones provide a beautiful solution. Let’s now begin the journey into the world of volatility and learn how you can be a better judge of options prices.