The Upside of Market Volatility

The volatility present in the market is always mentioned in a negative manner. However, if one looks carefully at the function performed by market volatility, this negative connotation seems unnecessary. This is because, in the absence of volatility, making profits would also be impossible. It is this volatility, which enables the fluctuation of prices that leads to profits for traders. However, not all firms are able to benefit from volatility. The firm must have some kind of competitive advantage in order to benefit from this volatility. The different types of competitive advantages, as well as the actions taken by firms in order to take risks in a prudent manner, have been mentioned in this article.

Types of Competitive Advantage

Firms developed different kinds of trading strategies in order to ensure that they have a competitive advantage over their peers. Some of these strategies have been mentioned below:

  1. Information Advantage: The market prices of securities are a direct function of the information that the market has about these securities. Hence, if any organization is able to have faster access to information than its peers, then it is in a better position to take advantage of the volatility. As a result, many firms subscribe to proprietary databases which collate information about the firm from various sources in order to get this advantage. It is also common for firms to hire dedicated analysts who track certain types of securities. However, there is a thin line between information advantage and insider trading. Insider trading is illegal and dangerous and can land investors in prison.

  2. Speed Advantage: The market takes a certain amount of time to process and absorb the information. For instance, when information about a certain company is released, market analysts have built-in models where they enter the variables to see how the cash flow will be affected. Also, certain companies want to enable high-speed trading and hence co-locate in the exchange premises. This co-location gives them speed advantages of a few milliseconds. However, that is also enough to consistently outperform the market.

  3. Flexibility Advantage: Some types of investment structures such as hedge funds are inherently more flexible as compared to other structures. Since they are not highly regulated, they can quickly make buy and sell decisions. This flexibility translates into speed advantage and enables superior returns. On the other hand, mutual funds and pension funds are highly regulated and hence cannot be as flexible.

  4. Deep Pockets: If an organization has the backing of an investor with deep pockets, then it can afford to survive longer and take on more losses. This provides the firm with an advantage wherein it can take on more risks and hence earn more returns for its investors.

  5. Knowledge Advantage: Lastly, there are some organizations that have survived for many years in the market. Hence, they have the experience which enables them to enact appropriately when market risks materialize and their firm is experiencing huge losses. This experience can save organizations millions of dollars in the long run.

Organization Culture and Risk-Taking

Over the years, it has been observed that some organizations are inherently better at risk-taking as compared to their peers. Hence, their success cannot be completely attributed to the skill of their people. This is because the people have changed over the years, but the organizational culture has not. Some building blocks of organizational cultures which enable better risk-taking have been mentioned below:

  1. Right Incentives: The risk-taking behavior of employees is driven by the manner in which the firm incentivizes such decision-making. If risk-taking is excessively rewarded, then the firm ends up taking massive risks. The opposite of this is also true and risk avoidance can also be built into the DNA of the firm. However, successful firms have realized that employees do not control the outcome. Hence, they should be rewarded or punished based on whether or not they followed the risk management process. The profit or loss caused as a result of the process is a risk which the organization should assume.

  2. Aligning Risk-Taking with Overall Strategy: Successful firms have realized that different risk-taking approaches work well with different market conditions and different strategies. Hence, they do not build their risk management approach in isolation. Instead, it is closely integrated with strategy and this approach gives them a competitive advantage.

  3. Training to Avoid Bias: Cognitive biases are one of the most important reasons that cause organizations to lose money. Successful firms realize that when risks materialize and losses are happening in abundance, these cognitive biases can get accentuated. Hence, firms provide training to their employees which helps them make better decisions during strenuous times.

  4. Hiring the Right People: Lastly, risk management can be a stressful job. Hence, it is important that the firm only hire candidates who are mentally strong and hence can handle the pressure.

    Risk management also requires a high level of quantitative skill. However, if the person only has the technical skill and lacks mental toughness, they are likely to get overwhelmed during the decision-making process. Hence, they might end up making the wrong decision.

To sum it up, it can be said that there is an upside to market volatility. There are some firms that have been able to capitalize on it consistently. This is because of their competitive advantage. The organizational culture also plays a huge role in the success or failure of the organization, when it comes to dealing with volatility.

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Risk Management