Chapter 36: The Basics of Volatility Trading 743 
prediction that is somewhat "middle of the road," since an extreme prediction is 
more likely to be wrong. Of course, it turns out to be wrong anyway, since actual 
volatility jumps around quite rapidly. 
The few charts that have been presented here don't constitute a rigorous study 
upon which to draw the conclusion that implied volatility is a poor predictor of actu­
al volatility, but it is this author's firm opinion that that statement is true. A graduate 
student looking for a master's thesis topic could take it from here. 
VOLATILITY TRADING 
As a result of the fact that implied volatility can sometimes be at irrational extremes, 
options may sometimes trade with implied volatilities that are significantly out of line 
with what one would normally expect. For example, suppose a stock is in a relatively 
nonvolatile period, like the price of the stock in Figure 36-2, just before point A on 
the graph. During that time, option sellers would probably become more aggressive 
while option buyers, who probably have been seeing their previous purchases decay­
ing with time, become more timid. As a result, option prices drop. Alternatively stat­
ed, implied volatility drops. When implied volatilities are decreasing, option sellers 
are generally happy (and may often become more aggressive), while option buyers 
are losing money (and may often tend to become more timid). This is just a function 
of looking at the profit and loss statements in one's option account. But anyone who 
took a longer backward look at the volatility of the stock in Figure 36-2 would see that 
it had been much more volatile in the past. Consequently, he might decide that the 
implied volatility of the options had gotten too low and he would be a buyer of 
options. 
It is the volatility trader's objective to spot situations when implied volatility is 
possibly or probably erroneous and to take a position that would profit when the 
error is brought to light. Thus, the volatility trader's main objective is spotting situa­
tions when implied volatility is overvalued or undervalued, irrespective of his outlook 
for the underlying stock itself. In some ways, this is not so different from the funda­
mental stock analyst who is attempting to spot overvalued or undervalued stocks, 
based on earnings and other fundamentals. 
From another viewpoint, volatility trading is also a contrarian theory of invest­
ing. That is, when everyone else thinks the underlying is going to be nonvolatile, the 
volatility trader buys volatility. When everyone else is selling options and option buy­
ers are hard to find, the volatility trader steps up to buy options. Of course, some rig­
orous analysis must be done before the volatility trader can establish new positions, 
but when those situations come to light, it is most likely that he is taking positions 
opposite to what "the masses" are doing. He will be buying volatility when the major-