Chapter 39: Volatility Trading Techniques 813 
watching the situation for those stocks that they will rarely let volatility get to the 
extremes that one would consider "too high" or "too low." Yet, with the large num­
ber of optionable stocks, futures, and indices that exist, there are always some that 
are out of line, and that's where the independent volatility trader will concentrate 
his efforts. 
Once a volatility extreme has been uncovered, there are different methods of 
trading it. Some traders - market-makers and short-term traders - are just looking 
for very fleeting trades, and expect volatility to fall back into line quickly after an 
aberrant move. Others prefer more of a position traders' approach: attempting to 
determine volatility extremes that are so far out of line with accepted norms that it 
will probably take some time to move back into line. Obviously, the trader's own sit­
uation will dictate, to a certain extent, which strategy he pursues. Things such as 
commission rates, capital requirements, and risk tolerance will determine whether 
one is more of a short-term trader or a position trader. The techniques to be 
described in this chapter apply to both methods, although the emphasis will be on 
position trading. 
TWO WAYS VOLATILITY PREDICTIONS CAN BE WRONG 
When traders determine the implied volatility of the options on any particular under­
lying instrument, they may generally be correct in their predictions; that is, implied 
volatility will actually be a fairly good estimate of forthcoming volatility. However, 
when they're wrong, they can actually be wrong in two ways: either in the outright 
prediction of volatility or in the path of their volatility predictions. Let's discuss both. 
When they're wrong about the absolute level of volatility, that merely means that 
implied volatility is either "too low" or "too high." In retrospect, one could only make 
that assessment, of course, after having seen what actual volatility turned out to be 
over the life of the option. The second way they could be wrong is by making the 
implied volatility on some of the options on a particular underlying instrument much 
cheaper or more expensive than other options on that same underlying instrument. 
This is called a volatility skew and it is usually an incorrect prediction about the way 
the underlying will perform during the life of the options. 
The rest of this chapter will be divided into two main parts, then. The first part 
will deal with volatility from the viewpoint of the absolute level of implied volatility 
being "wrong" (which we'll call "trading the volatility prediction"), and the second 
part will deal with trading the volatility skew.