Chapter 31,: 1be Basics of Volatility Trading 747 
implied volatility is high. Given that fact, he can then construct positions around a 
neutral strategy or around his view of the future. The time when the volatility seller 
must be careful is when the options are expensive and no one seems to know why. 
That's when insider trading may be present, and that's when the volatility seller 
should defer from selling options. 
CHEAP OPTIONS 
When options are cheap, there are usually far less discernible reasons why they have 
become cheap. An obvious one may be that the corporate structure of the company 
has changed; perhaps it is being taken over, or perhaps the company· has acquired 
another company nearly its size. In either case, it is possible that the combined enti­
ty's stock will be less volatile than the original company's stock was. As the takeover 
is in the process of being consummated, the implied volatility of the company's 
options will drop, giving the false impression that they are cheap. 
In a similar vein, a company may mature, perhaps issuing more shares of stock, 
or perhaps building such a.., good earnings stream that the stock is considered less 
volatile than it formerly was. Some of the Internet companies will be classic cases: In 
the beginning they were high-flying stocks with plenty of price movement, so the 
options traded with a relatively high degree of implied volatility. However, as the com­
pany matures, it buys other Internet companies and then perhaps even merges with a 
large, established company (America Online and Time-Warner Communications, for 
example). In these cases, actual (statistical) volatility will diminish as the company 
matures, and implied volatility will do the same. On the surface, a buyer of volatility 
may see the reduced volatility as an attractive buying situation, but upon further 
inspection he may find that it is justified. If the decrease in implied volatility seems 
justified, a buyer of volatility should ignore it and look for other opportunities. 
All volatility traders should be suspicious when volatility seems to be extreme -
either too expensive or too cheap. The trader should investigate the possibilities as to 
why volatility is trading at such extreme levels. In some cases, the supply and demand 
of the public just pushes the options to extreme levels; there is nothing more involved 
than that. Those are the best volatility trading situations. However, if there is a hint 
that the volatility has gotten to an extreme reading because of some logical (but per­
haps nonpublic) reason, then the volatility trader should be suspicious and should 
probably avoid the trade. Typically this happens with expensive options. 
Buyers of volatility really have little to fear if they miscalculate and thus buy an 
option that appears inexpensive but turns out not to be, in reality. The volatility buyer 
might lose money if he does this, and overpaying for options constantly will lead to 
ruin, but an occasional mistake will probably not be fatal.