Mar

25

PhilMost of us spend our whole lives trying to predict the direction of the market. Usually the results are, at best, only moderately successful. Market direction is the most difficult to predict, but as has been discussed here volatility is sometimes easier to predict because there is demonstrably more serial correlation.

Assuming we had both a direction and change in volatility model how would it be used? One way is to look at the cases. They are:

direction volatility

up        up

up        down

down     up

down     down

We could use simple option strategies depending on our outlook for volatility. When vol is expected to rise we would want to be long options. When vol is expected to fall we would want to sell options.

The choice of the option then is controlled by our expected directional outlook. The following table covers the cases:

direction volatility strategy

up         up         Buy call

up        down      Sell Put

down     up         Buy Put

down    down     Sell Call

It is worth noting, in passing, that direction and vol are generally negatively correlated. This implies that the cases up/up and down/down are relatively rare. The other two cases will occur more often.

Perhaps others can suggest different strategies within this framework.

Steve Bal responds:

I would suggest that volatility and direction are both a matter of time. One is obviously a matter of timing the market (as there may not be another time for a top/bottom) and volatility is a matter of time - time that it takes to revert to the mean.

A different strategy may be playing the time frame of volatility. In this exercise on would try to time the daily volatility within the context of weekly/monthly volatility of time.

In this scenario if your daily timing of volatility is wrong there is the possibility that time may be on your side over the longer term. I would never suggest relying on hope (of the longer term) but to reduce/hedge positions if volatility is not on your side.


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2 Comments so far

  1. James Schroeder on March 26, 2008 11:06 am

    I don’t think it’s as simple as implied volatility and price are negatively correlated. Perhaps in the equity and equity index market this is the case, but in most commodities it is not. Interest rates and currencies are different animals entirely and the “skew” moves around in them depending on which direction the “panic” is to.

    I’m not saying that this is always the case, of course there are times when commodity prices and implied vol will be negatively correlated, but for the most part these relationships are positive.

  2. Anon on March 26, 2008 6:32 pm

    "It is worth noting, in passing, that direction and vol are generally negatively correlated. This implies that the cases up/up and down/down are relatively rare. The other two cases will occur more often."At least for equities Victor & Laurel have asserted the opposite — you may want to review the archives.

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