Happy Thanksgiving, everyone! I’ve wrote a lot so far about how we will be trading volatility versus price action, and a natural question that might arise is what tools or indicators we will use to identify opportunities. Traders that look to exploit opportunities in price action such as scalpers and trend traders will often use technical support/resistance levels or indicators to make their trades. This is possible because price action behaves differently than volatility. I often hear people refer to instrument prices as “random,” and that’s only sort of true, and leaves out a lot of important subtlety. What is closer to the truth is that instrument returns are random, but even then not in the typical way we use the word “random.”

In literature as well as several popular options pricing models, returns are represented with a type of stochastic process called Geometric Brownian Motion. A stochastic process is one where the variable at time t (i.e. today’s return) is random but also partially dependent on the variable at time t-1 (yesterday’s return). If returns were truly random, with each discrete return being i.i.d., today’s return would have absolutely no effect on tomorrow’s. Anyone that has watched the market for more than a day knows this is not the case, but I will leave the proof as an exercise to my readers.

Volatility, on the other hand, exhibits much different behavior. While it is also often modeled stochastically, volatility exhibits a very special behavior that returns do not: clustering. All clustering means is that while we may see periods of elevated volatility, over time volatility tends to revert towards a long term mean. When people call volatility “mean-reverting,” this is what they are referring to. This clustering behavior is what allows us to trade volatility, and understanding it is crucial to cashing checks.

If we believe volatility clustering to be true, then we also believe that when volatility is especially elevated it will eventually revert to a long term mean. By extension, we also believe that when volatility is priced towards that long term mean, eventually we will see a cluster of higher volatility above that mean. This is the foundation of trading volatility.