CHAPTER 36 
The Basics of 
Volatility Trading 
Volatility trading first attracted mathematically oriented traders who noticed that the 
market's prediction of forthcoming volatility - for example, implied volatility - was 
substantially out of line with what one might reasonably expect should happen. 
Moreover, many of these traders (market-makers, arbitrageurs, and others) had 
found great difficulties with keeping a "delta neutral" position neutral. Seeking a bet­
ter way to trade without having a market opinion on the underlying security, they 
turned to volatility trading. This is not to suggest that volatility trading eliminates all 
market risk, turning it all into volatility risk, for example. But it does suggest that a 
certain segment of the option trading population can handle the risk of volatility with 
more deference and aplomb than they can handle price risk 
Simply stated, it seems like a much easier task to predict volatility than to pre­
dict prices. That is said notwithstanding the great bull market of the 1990s, 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. Consider the chart 
in Figure 36-1. This seems as if it might be a good stock to trade: Buy it near the lows 
and sell it near the highs, perhaps even selling it short near the highs and covering 
when it later declines. It appears to have been in a trading range for a long time, so 
that after each purchase or sale, it returns at least to the midpoint of its trading range 
and sometimes even continues on to the other side of the range. There is no scale on 
the chart, but that doesn't change the fact that it appears to be a tradable entity. In 
fact, this is a chart of implied volatility of the options on a major U.S. corporation. It 
really doesn't matter which one (it's IBM), because the implied volatility chart of near­
ly every stock, index, or futures contract has a similar pattern - a trading range. The 
only time that implied volatility will totally break out of its "normal" range is if some­
thing material happens to change the fundamentals of the way the stock moves - a 
takeover bid, for example, or perhaps a major acquisition or other dilution of the stock 
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