The information to be presented here is not overly theoretical. All of the concepts should be able to be understood by most option traders. Whether or not one chooses to actually "trade volatility", it is nevertheless important for an option trader to understand the concepts that underlie the basic principles of volatility trading.
Why Trade "The Market"?
The "game" of stock market predicting holds appeal for many because one who can do it seems powerful and intelligent. Everyone has his favorite indicators, analysis techniques, or "black box" trading systems. But can the market really be predicted? And if it can't, what does that say about the time spent trying to predict it? The answers to these questions are not clear, and even if one were to prove that the market can't be predicted, most traders would refuse to believe it anyway. In fact, there may be more than one way to "predict" the market, so in a certain sense one has to qualify exactly what he is talking about before it can be determined if the market can be predicted or not.
The astute option trader knows that market prediction falls into two categories: 1) the prediction of the short-term movement of prices, and 2) the prediction of volatility of the underlying. These are not independent predictions. For example, anyone who is using a "target" is trying to predict both. That's pretty hard. Not only do you have to be right about the direction of prices, but you also have to be able to predict how volatile the underlying is going to be so that you can set a reasonable target. In certain cases, the first prediction can be made with some degree of accuracy, but the second one is extremely difficult.
Nearly every trader uses something to aid him in determining what to buy and when to buy it. Many of these techniques, especially if they are refined to a trading system, seem worthwhile. In that sense, it appears that the market can be predicted. However, this type of predicting usually involves a lot of work, including not only the initial selection of the position, but money management in determining position size, risk management in placing and watching (trailing) stops, etc. Thus, it's not easy.
To make matters even worse, most mathematical studies have shown that the market can't really be predicted. They tend to imply that anyone who is outperforming an index fund is merely "hot" - has hit a stream of winners. Can this possibly be true? Consider this example. Have you ever gone to Las Vegas and had a winning day? How about a weekend? What about a week? You might be able to answer Ayes" to all of those, even though you know for a certainty that the casino odds are mathematically stacked against you. What if the question were extended to your lifetime? Are you ahead of the casinos for your entire life? This answer is most certainly "no" if you have played for any reasonably long period of time.
Mathematicians have tended to believe that outperforming the broad stock market is just about the same as beating the casinos in Las Vegas possible in the short term, but virtually impossible in the long term. Thus, when mathematicians say that the stock market can't be predicted, they are talking about consistently beating the "index" - say, the S&P 500 over a long period of time.
Those with an opposing viewpoint, however, say that the market can be beat. That the "game" is more like poker where a good player can be a consistent winner through money management techniques than like casino gambling, where the odds are fixed. It would be impossible to get everyone to agree for sure on who is right. There's some credibility in both viewpoints, but just as it's very hard to be a good poker player, so it is difficult to beat the market consistently with directional strategies. Moreover, even the best directional traders know that there are large swings or drawdowns in one's net worth during the year. Thus, the consistency of returns is generally erratic for the directional trader.
This inconsistency of returns, the amount of work required, and a necessity to have sufficient capital and to manage it well are all things that can lead to the demise of a directional trader. As such, short-term directional trading probably is not really a "comfortable" trading strategy for most traders and if one is trading a strategy that he is not comfortable with, he is eventually going to lose money doing it.
So, is there a better alternative? Or should one just pack it in, buy some index funds and forget it? As an option strategist, one should most certainly feel that there's something better than buying the index fund. The alternative of volatility trading really offers significant advantages in terms of the things that make directional trading difficult. So if one finds that he is able to handle the rigors of directional trading, then stick with that approach. He might want to add some volatility trading to your arsenal, though, just to be safe. However, if one finds that directional trading is just too time-consuming, or he has trouble utilizing stops properly, or is constantly getting whipsawed, then it's time to concentrate more heavily on volatility trading, preferably in the form of straddle buying.
There was an extremely interesting comment in an article on chaos theory, that has some application to volatility trading. I don't expect most readers to be familiar with that chaos theory of mathematics/physics. However, anyone should be able to grasp the general theory, which states that a small change in a seemingly irrelevant place can have great affects perhaps even chaotic ones later on in time. It applies to many areas of nature and some have tried to apply it to the stock market as well, especially after the crash of >87 which didn't seem predictable by any "standard" branch of mathematics, but did seem possible under chaos theory.
In the article, it was pointed out that some systems just can't be predicted. Chaos theory also aids in determining that fact as well. For example, chaos theory provides some evidence that earthquakes cannot be predicted. Is this a useful piece of information, or just some irrelevant trivia? In fact, it is quite useful and important. The article quotes mathematical physicist Henrik Jensen as saying, "It's pretty important if you can say you will never be able to predict earthquakes. Instead you should concentrate on building quality houses."
I thought that comment was very apropos to the stock market. If chaos theory says that we can't predict the stock market and many say that it does then perhaps we should stop trying to do so and instead should concentrate on building quality strategies. Such a strategy would certainly be volatility trading especially straddle buying when implied volatility is low.
Volatility Trading Overview
Volatility trading first attracted mathematically oriented traders who noticed that the market's prediction of forthcoming volatility (i.e., implied volatility) was substantially out of line with what one might reasonably expect should happen. Moreover, many of these traders (market makers, arbitrageurs, and others) had found great difficulties with keeping a Adelta neutral" position neutral. Seeking a better way to trade without having a market opinion on the underlying security, they turned to volatility trading. This is not to suggest that volatility trading eliminates all market risk turning it all into volatility risk, for example. But it does suggest that a certain segment of the option trading population can handle the risk of volatility with more deference and aplomb than they can handle price risk.
Simply stated, it seems like a much easier task to predict volatility that to predict prices. That is said, notwithstanding the great bull market of the 90's in which every investor who strongly participated certainly feels that he understands how to predict prices. Remember not to confuse brains with a bull market. Consider the chart in Figure 1:
This seems like it might be a good stock to trade: buy it near the lows and sell it near the highs, perhaps even selling it short near the highs and covering when it later declines. It appears to have been in a trading range for a long time, so that after each purchase or sale, it returns at least to the mid-point of its trading range and sometimes even continues on to the other side of the range. There is no scale on the chart, but that doesn't change the fact that it appears to be a tradeable entity. In fact, this is a chart of implied volatility of the options of a major US corporation. It really doesn't matter which one (it's IBM) for the implied volatility chart of nearly every stock, index, or futures contract has a similar pattern - a trading range. The only times that implied volatility will totally break out of it's "normal" range is if something material happens to change the fundamentals of the way the stock moves - a takeover bid, for example, or perhaps a major acquisition or other dilution of the stock.
So, many traders observed this pattern and have become adherents of trying to predict volatility. Notice that if one is able to isolate volatility, he doesn't care where the stock price goes he is just concerned with buying volatility near the bottom of the range and selling it when it gets back to the middle or high of the range, or vice versa. In real life, it is nearly impossible for a public customer to be able to isolate volatility so specifically he will have to pay some attention to the stock price, but he still is able to establish positions in which the direction of the stock price is irrelevant to the outcome of the position. This quality is appealing to many investors who have repeatedly found it difficult to predict stock prices. Moreover, an approach such as this should work in both bull and bear markets.
Despite the neutral stance, there is risk in volatility trading. For example, if one decides to "buy" volatility, he will generally be buying options. Thus, he is at risk of time decay and he also has a risk that volatility might decrease while the position is in place. On the other hand, if one decided to sell options as his initial position (because volatility was "too high")_then he faces other risks: there is the risk that volatility could increase and thus cause losses, and if the options are naked options, there is the risk that the underlying instrument could move sharply a gap move and cause large losses. For this latter reason, we generally prefer to trade volatility from the long side or as a spread not with naked options.
Volatility trading has an appeal to a great number of individuals. Just remember that, for you personally to engage in a strategy, you must find that it appeals to your personal philosophy of trading. To try to use a strategy which you find uncomfortable will only lead to losses and frustration. So, if this somewhat neutral approach to option trading sounds interesting to you, then we should talk.