V.8:1 (17-20): Trading volatility by Andrew Sterge

V.8:1 (17-20): Trading volatility by Andrew Sterge
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Trading volatility by Andrew Sterge

In the winter and spring of 1989, I made a series of Eurodollar options trades which show the logic of "trading volatility." This sort of trading is the bread and butter of many institutional traders, that is to say, large, well-financed traders. Understanding what such traders do is vital to an independent trader. One of the first things to understand about volatility is that it does not exhibit long trends like some common stocks but is more cyclical (or "mean reverting") in nature. Thus, extremes in volatility are more likely opportunities to fade the market's volatility than chances to go with the breakout.

Such an opportunity to fade volatility occurred with Eurodollar options in early February 1989 when the implied volatility of these options was trading at extremely low levels between 14% and 15% in the very left tail of the frequency distribution for Eurodollar volatility as shown in Figure 1. Being at such extreme lows alerts the volatility trader for a possible trade on the long side, that is, to take advantage of volatility rising. The trick is to time the trade to take advantage of some event that leads to higher volatility. Otherwise, you suffer eroding premium in an inactive market.

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