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From Theory To Practice

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Volatility: Contraction & Expansion

From Theory To Practice

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

As premium sellers, a big part of our trading style is positioned for volatility contraction. Volatility and option prices have a positive relationship (they move in the same direction), so if volatility contracts, then option prices will fall. Volatility itself is normally in a state of contraction, as evidenced by the positive drift that we saw in the Geometric Brownian Motion model or the contango that usually exists in the /VX futures market. However, volatility doesn’t always contract; it can expand, too. And, when it does, it can happen quickly and explosively. We take a look at both daily and weekly movements in the VIX to support this idea.

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