Price Volatility

Volatility is where leverage and risk meet. Without price movement, there would be nothing for a speculator to profit from and nothing to lose to. This section covers why volatility is the source of both, and why it becomes so powerful once leverage is added on top.

Volatility Is the Source of Both Opportunity and Risk

The mistake students make is treating volatility as a hazard. It is really the raw material of speculation, and it points both ways.

• Price volatility is the degree to which a futures price moves up and down over time. Futures prices can move sharply.
• Volatility creates the speculator's opportunity: without price movement, there would be no profit to pursue from a directional bet. A flat price pays no one.
• The same volatility creates the speculator's risk: a sharp move can go against the position just as easily as for it. Nothing about volatility promises the move will be the one the trader wanted.

Think of it this way: volatility is the wind a sailor needs. No wind, and the boat goes nowhere, there is no profit in a dead-calm market. But the same wind that carries the boat forward can just as easily drive it onto the rocks. The speculator cannot ask for movement in only the favorable direction; volatility is the movement itself, and it is indifferent to which way the trader is positioned.

Exam Tip: Gotchas

• Volatility is neutral, not one-sided. It is at once the reason a speculator can profit and the reason a speculator can lose. An answer that treats volatility as only an opportunity, or only a danger, misses the point.

Volatility Interacts With Leverage

Volatility and leverage are not two separate topics. They multiply each other, and that product is what makes futures high-risk for speculators.

• Volatility and leverage compound each other: a volatile price applied to a leveraged position produces large percentage swings on the small performance bond (the good-faith deposit that controls the much larger contract).
• This is why futures are considered high-risk instruments for speculators even though the up-front deposit is small: modest volatility, magnified by leverage, can produce outsized gains or losses on the cash committed.
• The lesson from the leverage section returns here with force: because the return is measured against the small deposit, even ordinary day-to-day price movement can swing the account by a large percentage.

Think of it this way: leverage is a magnifying glass held over volatility. A price wobble that would be minor against the full contract value becomes dramatic once it is measured against the small deposit. Put a long lever (leverage) and a lively price (volatility) together and you get the defining trait of futures speculation: small deposits, large swings, in whichever direction the price happens to move.

Exam Tip: Gotchas

• Volatility and leverage compound. The reason a small deposit can be lost so fast is that a volatile price is being measured against that small deposit, not against the full contract value.
• Small up-front deposit does not mean low risk. Futures are high-risk for speculators precisely because leverage magnifies whatever a volatile price does.