“If you know the Way broadly you will see it in everything.”

Miyamoto Musashi

We all must follow some form of “The Way”

Volatility in financial terms can be (imperfectly) summarized as change. There is expected change and unexpected change. To be “long volatility” is to bet that change will be greater than expected. Generally speaking, that means you are wrong most of the time but when you’re right you are right big. On the other hand, to be “short volatility” is to bet that change will be less than expected. Also, you will be right most of the time but when you’re wrong, you won’t be having a good time. The example payoff diagrams for these strategies are as follows.

Another aspect of volatility is the difference between defined vs. undefined risk. The difference between the two is whether or not you know how much you can loose up front. In Options trading, when you are long options you have a defined amount that you pay upfront so your downside is limited to what you paid. If you are short options you collect a small amount of money up front but your potential downside is theoretically unlimited.

But what does this have to do with anything? Fair enough, but you will see these asymmetric payoff structures in other aspects of life.

A few examples of short-vol behaviors:

• The drunk driver, who saves a few bucks every time but eventually gets caught and faces the legal consequences (or worse).
• The cigarette smoker, who trades feeling good for a few minutes now for significant health problems later in life.
• The scheming co-worker, who will take any opportunity to take advantage of others to advance themselves who eventually get fired because no-one wants to work with them.

A few examples of long-vol behaviors :

• The entrepreneur who assumes the initial risk associated with starting a business in order to have the asymmetric payoff of being their own boss, financial independence, and personal autonomy.
• The student who consistently spends time studying in order to get good grades.
• The dieter who eats healthy and has a greater quality of life as a result.

It is important to understand that you can be long-vol does not guarantee success conversely being short-vol does guarantee failure. So the key is to understand the risks/reward profile of a set of behaviors and the probabilities associated with these strategies. For example, the drunk driver has a .05% of getting pulled over and charged. So they might get away with it once, twice or even 100 times. But as the number of occurrences increases the chance of getting caught almost becomes a certainty. So is it worth it?  

Related Content on the Subject

It is difficult to quickly summarize Nassim Nicholas Taleb’s books. But if you found this post interesting you will definitely enjoy his books. These books definitely changed the way I look at life and highly recommend everyone reads them.

Chris Cole runs a fund that specializes in volatility and has some interesting views on the subject. If you are a finance nerd like myself here are a couple of interviews with him on the subject.