So many times, the financial press makes ridiculous remarks about volatility. Consider this example from a nationally syndicated columnist. He writes,

If $100 gained 30 percent in even years and lost 10 percent in odd ones, it would grow to about $480 in 20 years... If it grew 10 percent every year, you'd end up with about $673.

Volatility is bad.

Actually, losing money every other year for twenty years is bad regardless of volatility. The reason this hypothetical investment underperforms 10% per year is because the geometric mean of -10% and +30% is less than +10%. Basic statistics tells us that

Volatility has nothing to do with it. The real problem is that this columnist doesn't seem to understand what volatility is.

Market analysts and economists all seem to have their own pet measures of volatility from last month's high minus last month's low to close-to-close change to standard deviation to more complex statistical measures. In all cases, the general consensus is that volatility is how much the market moves relative to price. For example, an instrument that goes from $10 to $10.10 is just as volatile as an instrument that goes from $100 to $101.

Volatility is also measured without regard to direction, so a price change from $10 to $11 is no more or less volatile than a price change from $10 to $9. Of course these measures of volatility are all dependent on the timeframe of measurement. Some analysts believe that daily measures of volatility are very informative while others prefer to measure volatility over longer timespans. By now, it may have occurred to you that over timespans of two years or more, an instrument that goes up in price 10% per year is actually more volatile than an instrument that alternates between +30% and -10%.

Volatility is good.

In terms of volatility, there are essentially two types of traders, those who put themselves in a position to be harmed by volatility and those who put themselves in a position to benefit from it.

In the former category are value investors (the kind that buy if the present price is below the present value, in hopes that the future price will converge to the present value), spread arbitrageurs, and technical analysts who rely on "overbought" and "oversold" indicators. Nearly all the market participants in this group subscribe to economic theories based on "equilibrium models." These investing styles work quite well so long as volatility remains within the bounds assumed by the trading model in use, just like picking up $100 bills in front of a moving bulldozer. Eventually, it moves out of those bounds.

The latter category of traders consists of option buyers, certain types of fundamental traders, trend traders, and fractal traders, including iSigma. Since volatility is bounded only on one side, at zero, the traders who survive and succeed in the markets are those who put themselves in a position to benefit from volatility. Traders in this group are the ones driving the bulldozer.

In the capital markets, volatilty is here to stay. While some, such as the author of the article quoted above, may claim that volatility is a source of danger, successful traders know it as the source of profits. Volatility is no more and no less than change in price, a necessary condition for a trade to pay off. The key to lasting profits is to trade from a coherent model, one which stands to benefit from volatility in the markets.