Is Volatility Good for Traders?

Is High Volatility Good for Traders?

I will break this question down to two in order to explain it:

  • Is high volatility good for traders in the short term?
  • Is high volatility good for traders in the long term?

Note that by traders I also mean investors. The difference between traders and investors is only in time horizon and frequency of trades, but the effects of volatility are the same.

Is Volatility Good for Traders in the Short Term?

In the short term, for a particular trade or position, it always depends on which trade or position the trader has at the moment.

Every trade and every position you can have in the markets is in fact a bet on direction of a market (stock price, interest rate, currency exchange rate etc.), volatility of a market, or a combination of both.

  • You can be long direction (for example when you buy a stock) or short direction (when you sell a stock short or keep it underweight against your benchmark).
  • Similarly, you can be long volatility or short volatility (typically using options on the underlying security or volatility instruments if they are available – for example VIX futures or options in case of the S&P500).

When you are long volatility, your position makes a profit when volatility increases. For example, when you buy a straddle (a combination of long call and long put with the same strike price), you make a profit when the underlying security moves away from the strike price (realized volatility goes up) or at least when the market expects better odds of a possible move away from the strike price (implied volatility goes up). If volatility does not increase, you will lose money with passing time, as long volatility positions usually cost money to maintain over time.

When you are short volatility, for example you take the other side of the trade above and sell a straddle, your position makes a profit when volatility declines or when it does not increase fast enough.

To sum up:

  • When you are long volatility, higher volatility is good for you.
  • When you are short volatility, higher volatility is bad for you.

When you are neutral on volatility and your position only bets on price direction (e.g. a stock going up or down), volatility itself does not have any effect on your profit or loss in the short term, but it is still important in the long term.

Is Volatility Good for Traders in the Long Term?

Even when you never trade volatility directly (no options, no VIX etc.), volatility is good for you in the long term. Indeed, it is necessary for you to make a profit.

Volatility means how much something moves. High volatility means that a stock’s price moves a lot.

Even if you were the best trader in the world, you would never make any profit on a stock with a constant price (zero volatility).

In the long term, volatility is good for traders because it gives them opportunities. Without volatility there would be no trading opportunities and no traders.

When High Volatility is Bad

There are situations when too high volatility can be bad, because volatility goes hand in hand with risk (see Is Volatility the Same as Risk?). However, in such cases it is usually the wrong direction doing the harm. The high volatility only means that the adverse move and the losses are too big in relation to the portfolio. High volatility by itself is not bad, but it can become bad when combined with mismanagement of risk (typically too big positions in relation to the portfolio size).

Things get more complicated if you are a professional portfolio manager and manage money for clients. Investors require high return and low risk and when there are two managers both making 10% per year on average, but with different volatility of the portfolio, most rational investors would choose the one with lower volatility (lower risk), other things being equal.

So Is Volatility Good in General?

In the short run, in one particular trade, it depends on whether you are long or short volatility. If you are neutral on volatility, it does not matter directly, but higher volatility can make your profits or your losses bigger.

In the long run, volatility is what enables us to speculate in the markets. Even when you are a long term investor and “buy and hold”, you would never make any money without prices changing.