Volatility Definition
In finance, volatility is a statistical measurement of up and down asset price fluctuations over time. If an asset has rapid dramatic price swings, volatility will be high. If prices are consistent and rarely change, volatility is low. Volatility can be measured as the annualized standard deviation.

Volatility as Measure of Risk
Volatility is often used to measure risk. Many common measurements of risk, such as beta, utilize volatility in calculations. It makes sense that an asset that has had huge price swings is more risky than an asset that is not volatile.

Upside vs. Downside Volatility
However, the actual effectiveness of using volatility as a measurement of risk is questionable. The main imperfection of volatility is that it does not differentiate upside and downside price movements. For example, assume a stock decreased in price from $10 to $2. Also assume that the stock exhibited low volatility before this price decrease. In this example, volatility was lower when the stock price was $10 then when the stock price was $2. If volatility was being used a measure of risk in this example, then when the stock priced at $10 it would have been less risky. This assumption is not logical.

Limitations of Predictions
In addition, volatility is a measurement over time that relies on historical data. Past events, however, do not guarantee future results. Using historical volatility as a predictive measure of future risk is thus limited by the uncertainty of future returns. In the financial markets, somewhat unpredictable future returns and radical events are especially prevalent.

Despite imperfections, estimating risks using volatility an important part of risk managements, but the predictive limitations of the measurements needs to be considered.

Famous Quotes About Volatility and Risk

“The true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.” - 1993 Shareholders Letter by Warren Buffet”Berkshire’s whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to. I think you’d have to believe in the tooth fairy to believe that you could easily outperform the market by seven-percentage points per annum just by investing in high volatility stocks. Yet many people still believe it. But Berkshire never paid any attention to it.” - Charlie Munger

VIX - The CBOE Volatility Index
VIX, often referred to as the investor fear guage, is the ticker symbol for the Chicago Board Options Exchange(CBOE) Volatility Index. The VIX is based on implied volatility of a wide variety options available on the S&P 500 index and is calculated in real time by the CBOE. This index allows expected volatility to be traded through the use of futures. There are also other variations of the VIX. The VXD tracks the Dow Jones Industrial Average. The VXN tracks the Nadsaq 100 index.

Related Sites:
http://www.tilsonfunds.com/MungerUCSBspeech.pdf
http://www.aetheling.com/MI/Volatility/index.html
http://www.888options.com/classes/volatility/introduction_01.jsp

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