Trading and Exchanges Chapter 20: Volatility and Why Prices Bounce Around
Chapter 20 is one of the shorter chapters in the book, but it covers something every trader thinks about constantly: volatility. Why do prices move? Why do they sometimes move way more than the actual news justifies? Harris breaks it down into two types and explains why the distinction matters more than most people realize.
What Volatility Actually Is
Volatility is just the tendency for prices to change unexpectedly. That is it. Prices move because new information arrives, or because impatient traders push prices around while trying to get their orders filled.
The thing about volatility is that it changes over time. Some weeks the market barely moves. Other weeks, everything is swinging 3% a day and your portfolio looks like an EKG. Those episodes of wild price swings are called episodic volatility, and they scare a lot of people.
But here is the key insight from Harris: volatility is not one thing. It has two completely different sources, and confusing them is a serious mistake.
Fundamental Volatility: The World Actually Changed
Fundamental volatility happens when real information about an instrument’s value changes unexpectedly. A killer frost hits Florida overnight, and orange juice futures open way higher the next morning. That is fundamental volatility. The underlying value of the thing actually shifted.
What factors cause it? Depends on what you are trading. For commodities, it is supply and demand conditions plus storage costs. For bonds, interest rates and credit quality. For stocks, management quality, technology, competitive position, and interest rates. For currencies, inflation, macro policy, and trade flows.
Here is a subtle point Harris makes: expected changes in fundamentals do NOT cause volatility. If everyone already knows a company will report strong earnings, that information is already in the price. Only the unexpected part moves things. This is why informative prices follow a random walk. Not because the market is chaotic, but because the predictable parts are already priced in.
Some instruments are naturally more volatile than others. Tech stocks are volatile because their values depend on research outcomes and markets that do not exist yet. High P/E stocks are volatile because growth expectations rely on many uncertain future factors. Highly leveraged firms are volatile because equity holders absorb most of the swings in asset values while bondholders sit in their protected layer.
Harris gives a great example with electricity in California during 2000-2001. Electricity is basically impossible to store. It is the ultimate perishable commodity. When demand exceeded what generators could produce, prices spiked insanely for short periods. Gasoline and heating oil have similar issues. Only about 9 days of US gasoline consumption sits in storage at any time. Any disruption, whether weather, refinery accidents, or economic shifts, causes wild price swings because you just cannot buffer the mismatch.
The general rule: high storage costs plus inelastic demand plus long production pipelines equals extreme volatility.
Transitory Volatility: Noise From Impatient Traders
This is the second type, and it is entirely different. Transitory volatility happens when impatient uninformed traders push prices away from fundamental values. These price changes are called transitory because they eventually revert. The price bounces away from true value and then comes back.
The simplest form is bid/ask bounce. Market order buyers hit the ask price. Market order sellers hit the bid. The recorded price just jumps back and forth between bid and ask even when nothing fundamental has changed. That back-and-forth creates measured volatility that has nothing to do with actual value changes.
But it goes beyond bid/ask bounce. Large orders from uninformed traders can push prices significantly away from fair value. When that happens, value traders and arbitrageurs eventually notice the gap and trade against it, pushing prices back. The whole cycle, the push away and the reversion back, is transitory volatility.
Here is why this matters: transitory volatility and transaction costs are basically the same thing seen from different angles. The price impact that uninformed traders suffer IS their transaction cost. And those same price impacts ARE transitory volatility. So liquid markets have low transitory volatility, and illiquid markets have high transitory volatility. They are two sides of the same coin.
How to Tell Them Apart
Total volatility equals fundamental volatility plus transitory volatility. People measure total volatility using variance, standard deviation, or mean absolute deviation of price changes. But separating the two types requires statistical models.
The trick is in their behavior. Fundamental price changes are essentially random and do not revert. If a stock drops because the company lost a major contract, it stays down. Transitory price changes DO revert. The price bounces down when a big sell order hits, then recovers when value traders step in.
This reversion creates negative serial correlation in price changes. Increases tend to follow decreases and vice versa. Reversals happen more often than continuations. If you see strong negative serial correlation in a price series, you are looking at transitory volatility.
Harris describes Roll’s serial covariance spread estimator as the simplest model for decomposing these two components. It assumes fundamental values follow a random walk and observed prices equal fundamental value plus or minus half the bid/ask spread. The main weakness is that Roll’s model only captures reversion between adjacent price changes. If prices take multiple transactions to revert, the model underestimates transitory volatility.
Why Regulators Care
Regulators are very interested in this distinction because they can only do something about transitory volatility. Fundamental volatility is the market doing its job. Prices are supposed to change when the world changes. You cannot and should not try to stop that.
But if transitory volatility is high, it means the market is illiquid and not working well. That is something regulators can potentially fix through market structure rules. When people scream at regulators to “do something” about volatile markets, the first question should be: is this fundamental or transitory? Because if it is fundamental, intervening will only make things worse.
The Bottom Line
Volatility is not just “prices moving a lot.” It is two separate phenomena wearing the same mask. Fundamental volatility is the market digesting real information. Transitory volatility is the market being sloppy about matching buyers and sellers. Confusing them will lead you to wrong conclusions about risk, wrong predictions about future price behavior, and wrong ideas about what regulators should do. Knowing which type you are looking at is half the battle.
Previous: Chapter 19: Liquidity