Risk Latte - Volatility has tails and it can fly

Volatility has tails and it can fly

Rahul Bhattacharya
August 9, 2011

NassimTaleb, the veteran options trader and the celebrated author of the book Black Swan was once quite annoyed when someone on his trading floor suddenly started singing "Volare, Volare". It seems most of the traders on the floor of New York stock exchange have been singing, albeit in a rather hoarse voice, the same 1950s famous Italian song for the past one week.

Indeed, the global financial markets have been swinging and dancing to the tune of the song "Volare" recently.

"Volare" in Italian means "to fly". It comes from the Latin word "Volatilis". Financial markets are indeed flying; or, in other words, markets are crashing and volatility is on the rise. The VIX index, which is an index of the implied volatility of the S&P500 stock index was up 20% and hit 41.9 at one point in New York trading yesterday and some traders cried "Armageddon". One index trader in Hong Kong bemoaned to me over the phone today that "We're in the tails again!" And as the Dollar-Swiss Franc volatility recently hit 23 (read 23%) a terrified FX trader in Tokyo, who was massively short Swiss Franc, shouted out to his colleague across the floor, "Are we going to see 35 vols in USD/CHF this time?"

Volatility is all that matters in the financial markets these days. Everybody, from the floor traders to the interbank dealers to the G7 Finance ministers and financial journalists, talks about volatility. It has come to dominate our lives.

But, what is volatility? A profound and a silly question, it is. We all know what "volatility" is and yet all of us will have difficulty in explaining the concept articulately and in a concise manner. This is because volatility can mean different things to different people and in different context. Is it a fear gauge? Is it a statistical quantity? Is it a parameter in option pricing model? Is it an asset? In fact, it is all of these things and perhaps much more. Volatility is the most profound, and yet perhaps the most elusive concept both in the real financial markets and in the theory of quantitative finance.

In this column as well in the CFE Resource Centre, we would continue to look at some of the basic and advanced mathematical concepts surrounding this devil, "volatility", and try to understand, intuitively as well as analytically, how it enthralls, torments and finally decimates option traders and investors alike.

As a veteran options trader once told me, "Beware of volatility, it has tails and it can fly".

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