What is Volatility

What is volatility?

A friend asked me to clarify and quantify volatility I am talking about. For a more standard definition, you can find any finance textbook. Let’s discuss a little bit of my understanding here. In the financial and economy market, the No. 1 key word is expected / forecast / predictable. For every major econ or fin activity, there are bunch of analysts covering it. They will forecast it and the range of the forecast will be priced in before the event. Risk is defined as a departure of the forecast, to either side. A significant and constant departure actually means difficulty of forecast. If there is so much uncertainty in the near future, people tend to be “risk-off”.

Here is an example of predictable price behavior.

If the market is efficient, we should expect fluctuation. People need to have different opinions to form a buy-sell opportunity. Overall, treasury stays in its price channel with manageable movement. Overall in a long run showing in this chart, you roughly can make 300% easy and comfortable return over 30 years of time. The chart on bottom has a totally different look. It did not want to stay in lane, raised too fast and ruined the price channel. The damage was in 2000 and we are still paying it back.

In the stock market, an easy proxy of risk and volatility is moving average and standard deviation. Statistically, 2 Standard Deviation explains 95% of the movement in a normal distribution.

Standard deviation is also important in finance, where the standard deviation on the rate of return on an investment is a measure of the volatility of the investment.

Here is wiki Standard_deviation

Based on this concept, John Bollinger designed an indicator called Bollinger Bands. The default setup is 20 period moving average as the middle line and 2 STD on each side. Just think of it like a 2 lane road. When you are on the road, you want to be a nice driver. You should make yourself predictable, not too fast or too slow, stay in your lane. If the car in front of you is not only speeding, but also playing a zigzag game, hitting the shoulder on the left then hit the curb on the right, what do you think? I will take the closest exit and find the nearest Starbucks for a break. After things cool down, I will go back to the road again.

How about opening gaps? Gaps are caused by overnight trading in other markets such as Asia and Europe. If gaps are too big and too often, that is also a kind of volatility I don’t want to deal with. So the car in front is actually transformer. Instead of keeping on change lanes, this car is jumping from left to right.

Here is a chart showing some recent reckless driving of SPY which is the Electronic Trading Fund for SP 500 index and a good representative of the overall market. 

Check the details. How many times it hit the curb? How many times it was driving off-road? How many gaps that I cannot handle?

AGAIN, in a long run, it is not how much money you make, but the risk management, or how much money you avoid to lose, that protects you. Inflation and interest rate adjusted peak is in year 2000, unadjusted peak is 2007. If you buy at peak, you are still losing money.