So I wanted to write about the VIX (as promised in last week’s post on financial stress levels), but I realised that I needed to start with volatility.

Volatility is a buzzword.

And it’s not a bad buzzword – the finance-y folk love it.

Permit me a metaphor. Let’s assume that you’re this totally hot rich guy, and you’ve decided that you’re ready to go into the market for a more permanent attachment (although obviously, with an ironclad pre-nup). Because you’re rich, you can go in one of two directions*:
*Misogyny disclaimer – I’m disclaiming it. This is just a metaphor.

  1. Hot Latina model; or
  2. Wife material.

The latter direction is good for child-rearing, companionship, and sex that occasionally gets the adjective “perfunctory”.

Hot Latinas, on the other hand, have mood swings that make life exciting. And there is always the possibility that the Hot Latina Model could also be wife material. I mean – who’s to say?

So mood swings…seem sexy. With potential upside.

And volatility? Volatility is just the official term for what a share is doing when it acts like a hot Latina.

How It Interacts With Options

When you hear people talk about put options and call options, what they mean is:

  1. Can I pay you to have the right to sell this share to you at this price before this date? (the put option)
  2. Can I pay you to have the right to buy this share from you at this price before this date? (the call option)

How much you pay for those rights is dependent on four things:

  1. The current price;
  2. The price you’d like to buy/sell at (the exercise price);
  3. How long you want before the right expires (the date); and
  4. Volatility (how sexy is this thing?)

The first three factors are pretty concrete. The volatility is where it gets exciting. Or not exciting, as the case may be.

To return to my rich guy metaphor:

  1. Wife-material-shares means reliable and dependable. The price remains fairly consistent. What would you pay for an option here? Not a lot, really. If you buy it now, or you buy it in a month’s time, you’re unlikely to lose out and/or gain too much.
  2. Hot-Latina-shares are feisty. The price is all over the place, depending on mood and the pursuits of the other people in the market. And maybe you don’t want to go all in – because what if it turns out to be all spanx and make-up? On the other hand, it could be the share that does everything. So the option here is far more valuable.

The other way to think about volatility is to look at it like insurance. If there is a high risk of something happening, you’d charge a higher premium. And for lower risks, you get lower premiums.

To be picked up on Thursday…