Chapter 39: Volatility Trading Techniques 837 
buying a straddle, ask the question, "Has this stock been able to move far 
enough, with great enough frequency, to make this straddle purchase prof­
itable?") Use histograms to ensure that the past distribution of stock prices 
is smooth, so that an aberrant, nonrepeatable move is not overly influenc­
ing the results. 
Each criterion from Step 1 would produce a different list of viable volatility 
trading candidates on any given day. If a particular candidate were to appear on more 
than one of the lists, it might be the best situation of all. 
TRADING THE VOLATILITY SKEW 
In the early part of this chapter, it was mentioned that there are two ways in which 
volatility predictions could be "wrong." The first was that implied volatility was out of 
line. The second is that individual options on the same underlying instrument have 
significantly different implied volatilities. This is called a volatility skew, and presents 
trading opportunities in its own right. 
DIFFERING IMPLIED VOLATILITIES ON THE SAME UNDERLYING SECURITY 
The implied volatility of an option is the volatility that one would have to use as input 
to the Black-Scholes model in order for the result of the model to be equal to the 
current market price of the option. Each option will thus have its own implied volatil­
ity. Generally, they will be fairly close to each other in value, although not exactly the 
same. However, in some cases, there will be large enough discrepancies between the 
individual implied volatilities to warrant the strategist's attention. It is this latter con­
dition of large discrepancies that will be addressed in this section. 
Example: XYZ is trading at 45. The following option prices exist, along with their 
implied volatilities: 
Actual Implied 
Option Price Volatility 
January 45 call 2.75 41% 
January 50 call 1.25 47% 
January 55 call 0.63 53% 
February 45 call 3.50 38% 
February 50 call 4.00 45%