748 Part VI: Measuring and Trading Volatility 
Sellers of volatility, however, have to be a lot more careful. One mistake could 
be the last one. Selling naked calls that seem terrifically expensive by historic stan­
dards could be ruinous if a takeover bid subsequently emerges at a large premium to 
the stock's current price. Even put sellers must be careful, although a lot of traders 
think that selling naked puts is safe because it's the same as buying stock. But who 
ever said buying stock wasn't risky? If the stock literally collapses - falling from 80, 
say, to 15 or 20, as Oxford Health did, or from 30 to 2 as Sunrise Technology did -
then a put seller will be buried. Since the risk of loss from naked option selling is 
large, one could be wiped out by a huge gap opening. That's why it's imperative to 
study why the options are expensive before one sells them. If it's known, for exam­
ple, that a small biotech company is awaiting FDA trial results in two weeks,~and all 
the options suddenly become expensive, the volatility seller should not attempt to be 
a hero. It's obvious that at least some traders believe that there is a chance for the 
stock to gap in price dramatically. It would be better to find some other situation in 
which to sell options. 
The seller of futures options or index options should be cautious too, although 
there can't be takeovers in those markets, nor can there be a huge earnings surprise 
or other corporate event that causes a big gap. The futures markets, though do have 
things like crop reports and government economic data to deal with, and those can 
create volatile situations, too. The bottom line is that volatility selling - even hedged 
volatility selling - can be taxing and aggravating if one has sold volatility in front of 
what turns out to be a news item that justifies the expensive volatility. 
SUMMARY 
Volatility trading is a predictable way to approach the market, because volatility 
almost invariably trades in a range and therefore its value can be estimated with a 
great deal more precision than can the actual prices of the underlyings. Even so, one 
must be careful in his approach to volatility trading, because diligent research is 
needed to determine if, in fact, volatility is "cheap" or "expensive." As with any sys­
tematic approach to the market, if one is sloppy about his research, he cannot expect 
to achieve superior results. In the next few chapters, a good deal of time will be spent 
to give the reader a good understanding of how volatility affects positions and how it 
can be used to construct trades with positive expected rates of return.