CHAPTER 3

Volatility

As we’ve seen, the volatility of earnings for a company impacts the value of that company. Everything else being the same, the greater the volatility of earnings, the less valuable the company is. We’ve also seen that the volatility of a company affects the value of options. Everything else being the same, the greater the volatility of stock price, the more valuable the options on that company. Why? Because volatility equals risk.

Some will say that it’s bunk to equate volatility and risk. They’ll say that their risk is equal to their maximum potential loss; if they have invested $1,000 then their risk is $1,000. That may very well be true if they put the $1,000 into an Internet startup long before its initial public offering (pre-IPO). The potential for losing all of the $1,000 is very high. But what if they’d put the $1,000 into U.S. government bonds? The likelihood of losing $1,000 if it’s invested in U.S. government bonds is exceedingly small. It’s almost infinitesimal, but it’s not zero. The maximum potential loss is still $1,000. If we gauge risk by maximum potential loss, then we’d say U.S. government bonds are just as risky as a pre-IPO Internet startup. That doesn’t make much sense. We can do better.

RISK IS VOLATILITY

The concept of risk also has to factor in direction, time, magnitude, and speed. Even if we removed the potential of a U.S. government default from the example above—that is, if we were absolutely, metaphysically guaranteed that we’d ...

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