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Volatility Probability

Trading is much easier when you try to stay away from the losing team.  When markets are rising, do not short them.  When markets are falling, be wary of catching a falling knife.  To be successful at trading over the long haul, you do not have to be a winner all of the time, you just have to be a winner slightly more often then not.  If you cannot achieve a probability edge, then you need to be able to “cut your losers and let your winners run”.  If you are successful with both conditions, then let the money roll in.

Volatility is interesting because it is mean reverting, so we can generally say under normal times that 5% annualized volatility is low and 25% annualized volatility is high.  A lot of italics in the previous statement.  Due to the magnitude of the global financial recession, the extent of imbalances in current accounts, the size of government intervention and the massive debt load of developed country governments – I would call this less than a normal time.  This is why I continually expect the unexpected.  The risk flare can come from an earth quake, turbulence in the middle east, a missed payment by a Eurozone member, a collapse of commodity prices, a double dip in housing, an inability to raise the US debt ceiling, a spike in inflation, a subtle slowdown in the economy to stall speed, the withdrawal of government stimulus measures, or maybe something that is not even on our radar.  The point is that we are in fragile times with a global economic recovery that is anything but robust.  With that as a backdrop, we need to be prepared more for risk flares than a return to normalcy.

 

Return to normalcy or at the bottom of the range?

I read the above graph to mean that we are at the bottom of the risk level’s trading range rather than entering into normal trading volatility ranges.  I fully expect to see volatility spikes return on a regular basis for the next few years, so when implied volatility is below 15 I am more of a buyer than a seller of risk protection.

If you truly believe that the economic recovery is roaring, then rationalize the drop in the level of the economic surprise index (average % outperformance of economic data versus analyst/economist forecasts) versus a somewhat euphoric march upward in equities:

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Posted in Derivatives, Economics, Markets, Politics, Technical Analysis.

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2 Responses

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  1. Charlie Lefaux says

    I agree with your mindset re being more of a buyer below 15″ -I wanted to italicize “buyer” but can’t in the comment section. In fact, I want to be for the same reasons as well, “I would call this less than a normal time.”
    Yet, maybe that’s the thing.
    How many of us feel these aren’t normal times? When was the last time (without hindsight) you ever said, “these are normal times.”

  2. SurlyTrader says

    I agree that I am not an oracle and neither is anyone else, so I am not just buying volatility wherever I can. I believe there are ways that you can be smart about playing this feeling and I think that it currently looks attractive to buy 1-2 month ATM puts and sell 2-3 times as many longer term out of the money puts. This could be called a calendar ratio put spread? Just as an example -you can currently buy June ATM 1335 S&P puts trade at 13 vol, you can sell September 1100 puts at 25 vol.



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