Before we send off our first order, I’d like to spend some time discussing some of the finer details of how we will screen for good trades. Due to the fact that we will be trading volatility and not direction, we will be focusing on vol-related statistics rather than things like moving averages, ADR’s, and RSI’s.

Why Trade Volatility?

Volatility, unlike price, is mean reverting (see Natenburg’s “Option Volatility & Pricing” for a more thorough discussion). Most popular options pricing models assume returns to follow a lognormal distribution, but I have yet to see strong evidence showing this to be true. On the other hand, volatility can be easily shown to oscillate around a mean, making it much more reliable to trade than price.

Speaking qualitatively: would you rather short a stock that just tapped an ATH or sell volatility at the top of its 52-week range?

Volatility Measures

Another thing that makes trading volatility different than trading price is how we measure it. When it comes to price, we have a single absolute number (or time series) with which we derive our entry/exit points, trends, indicators, etc. With volatility, we have two values (implied and historical/realized) with which we compare to both each other and themselves over a longer time horizon. For now, we will look to take advantage of divergences between implied and historical volatility and implied volatility versus itself. The absolute volatility value is not in and of itself useful, rather, the relationships between volatility measures is where we will find our edge.

Will and Won’t

We will be looking to take advantage of the above listed opportunities as well as things like vol skew. For a small account, we won’t be doing higher level strategies like gamma scalping.