Volatility Trading: How Traders Can Take Advantage of Volatile Markets
Mar 3, 2022
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There is nothing more certain in the stock market than uncertainty itself. Random movements and unpredictable behaviors have and will govern the price action in the financial markets that we see on a daily basis. No one knows where prices will go. Not you. Not me. Not your favorite prognosticator on television with his latest surefire prognostication. This is the truth.
There is one asset, one metric, that moves in a fairly reliable fashion — volatility.
As the tastytrade research has shown over the years, the volatility in the market tends to mean revert over time. So volatility expansion is very often followed by volatility contraction, and volatility contraction is very often followed by volatility expansion. In other words, volatility’s mean tends to act like a magnet — pulling the spikes back down and paving the way for quick explosions during quieter periods.
OK — interesting, but here’s the even more fascinating part.
As the last couple years have shown, volatility spikes tend to quickly contract, but periods of low volatility can persist for lengthy windows of time with no corresponding high volatility to balance things back out. So while volatility certainly does mean revert, it does so in a very asymmetric fashion. With persistent volatility contraction set as the default setting, quick spikes can happen unexpectedly and out of nowhere, but they also tend to reverse course very quickly.
So what do we do? This is where the core tastytrade principle of selling premium in high implied volatility environments really shines. By patiently waiting for a high IV (or even better, a high IVR) situation, we position ourselves into a higher probability trade. With volatility already on the high side, at least relatively speaking, the odds are tipped in our favor that it will contract back to its mean, rather than expand to an even higher level. Thus, this volatility contraction will push option prices lower, benefiting anyone who sold premium beforehand.
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