Why Trade “The Market”? Just Trade “Volatility” Instead!

By Lawrence G. McMillan

The “game” of stock market predicting holds appeal for many because one who can do it seems powerful and intelligent.  Everyone has his favorite indicators, analysis techniques, or “black box” trading systems.  But can the market really be predicted?  And if it can’t, what does that say about the time spent trying to predict it?  The answers to these questions are not clear, and even if one were to prove that the market can’t be predicted, most traders would refuse to believe it anyway. 

Most mathematical studies have shown that the market can’t really be predicted.  They tend to imply that anyone who is outperforming an index fund is merely “hot” – has hit a stream of winners.   Can this possibly be true?  Consider  this example.  Have you ever gone to Las Vegas and had a winning day?  How about a weekend?  What about a week?  You might be able to answer “yes” to all of those, even though you know for a certainty that the casino odds are mathematically stacked against you.  What if the question were extended to your lifetime – are you ahead of the casinos for your entire life?  This answer is most certainly “no” if you have played for any reasonably long period of time.  

Mathematicians have tended to believe that outperforming the broad stock market is just about the same as beating the casinos in Las Vegas – possible in the short term, but virtually impossible in the long term.  Thus, when mathematicians say that the stock market can’t be predicted, they are talking about consistently beating the “index” – say, the S&P 500 – over a long period of time.  

In fact, there may be more than one way to “predict” the market, so in a certain sense one has to qualify exactly what he is talking about before it can be determined if the market can be predicted or not.  The astute option trader knows that market prediction falls into two categories: 1) the prediction of the short-term movement of prices, and 2) the prediction of volatility of the underlying.  Simply stated, it seems like a much easier task to predict volatility that to predict prices.  That is said, notwithstanding the great bull market of the ‘90's in which every investor who strongly participated certainly feels that he understands how to predict prices.  Remember not to confuse brains with a bull market.  The attraction of predicting volatility is that it almost always trades in a range – and a glance at the past history of volatility for any individual stock shows just what that range has been.

The simplest approach is to find situations where option implied volatility is low in relation to where it has been in the past and then consider buying straddles (i.e., simultaneously purchase a call and put with the same striking price and expiration date).   The straddles should have at least three months of life remaining – preferably more – in order to mitigate the negative effects of time decay.  Having found such a situation, one should then look at a chart of the stock to verify that it has, in the past,  been able to make moves with magnitude equal to or greater than the straddle price in the allotted time.

If one is able to isolate volatility, he doesn’t care where the stock price goes – he is just concerned with buying volatility near the bottom of its range and selling it when it gets back to the middle or high of the range, or vice versa.  In real life, it is nearly impossible for a public customer to be able to isolate volatility so specifically – he will have to pay some attention to the stock price, but he still is able to establish positions in which the direction of the stock price is irrelevant to the outcome of the position.  This quality is appealing to many investors – who have repeatedly found it difficult to predict stock prices.  Moreover, an approach such as this should work in both bull and bear markets.  Thus, volatility trading has an appeal to a great number of individuals.  Just remember that, for you personally to operate a strategy properly, you must find that it appeals to your personal philosophy of trading.  To try to use a strategy which you find uncomfortable will only lead to losses and frustration.  So, if this somewhat neutral approach to option trading sounds interesting to you, then consider adding it your arsenal of strategies.