The Pulse of the Market

In Chapter 20, Larry Harris tackles Volatility. Most people see volatility as “risk” or “scary price swings,” but Harris breaks it down into two very different components.

1. Fundamental Volatility (The “Good” Kind)

Fundamental volatility happens when the world changes.

• The Cause: A factory burns down, a new CEO is hired, or the Fed raises interest rates.
• The Effect: The price moves to a new level because the asset is truly worth more (or less) than it was five minutes ago.
• The Random Walk: These changes are unpredictable. If they were predictable, the price would have already moved.

Harris argues that fundamental volatility is necessary. If prices didn’t change as the world changed, we wouldn’t know where to put our money. It’s the economy’s way of processing new information.

2. Transitory Volatility (The “Noise”)

This is the kind of volatility caused by the “plumbing” of the market.

• The Cause: Uninformed traders demanding immediacy.
• Bid/Ask Bounce: If one person buys at the ask ($10.01) and then another sells at the bid ($10.00), the price “swings” by 1 cent even though nothing fundamental changed.
• Market Impact: A big seller dumps a block of shares and pushes the price from $100 to $95. Five minutes later, value traders realize it’s a bargain and push it back to $100.

Transitory volatility is “noisy” because it eventually reverts. If you see a price change that is immediately followed by a change in the opposite direction (negative serial correlation), you’re looking at transitory volatility.

Storage and Perishability

Why are some things, like electricity or fresh fish, so much more volatile than gold?

• Storage Costs: If it’s expensive to store something (like oil) or impossible (like electricity), you can’t keep a “buffer” inventory. Any tiny spike in demand causes a massive spike in price.
• Leverage: If a company has a lot of debt, its stock becomes a “high-beta” instrument. Small changes in the value of the company’s assets cause huge swings in the stock price.

Why Regulators Care

Regulators generally can’t (and shouldn’t) stop fundamental volatility—that’s just the world changing. But they hate transitory volatility. High noise means the market is illiquid and transaction costs are high.

When people complain that “the market is crazy,” they are usually talking about transitory swings. Regulators try to fix this by encouraging more liquidity providers to enter the market.

Summary: Signal vs. Noise

• Signal: Fundamental moves. Permanent price changes.
• Noise: Transitory moves. Prices that “bounce” and revert.

As a trader, your job is to ignore the noise and find the signal. Or, if you’re a dealer, your job is to profit from the noise.

Next time, we move into Part VI: Evaluation and Prediction. We’ll look at how to actually measure these transaction costs.

Next Post: Measuring Your Execution Quality