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Low Volatility & Reversion to the Mean

By:Dr. Jim Schultz

While higher volatility is preferred, low volatility markets provide for unique trading opportunities

  • As high-volatility premium sellers, a low implied volatility market presents challenges to us.
  • Still, however, using strategies that can benefit from a sudden rise in volatility can provide us with plenty of opportunities for new trades.
  • Our favorite low volatility strategies are diagonal spreads, calendar spreads, and long vertical spreads.

Being premium sellers at the core, we much prefer markets with high implied volatility. Waiting for volatility to rise before selling options can offer us several key advantages.

Not only do higher levels of volatility lead to higher option prices (a much better scenario for us since we are selling the options), but higher volatility also widens the expected moves in the underlying stock (since higher volatility is naturally predicting bigger price moves). These wider expected moves then lead to a larger buffer between the current stock price and the strike price on our option—another bonus for us that increases our probabilities with our out-of-the-money strike selection.

Volatility mean reversion

Thus, while higher volatility is much preferred over lower volatility, a lower-volatility market like the one we have today can still present us with opportunities for new trades. Empirically, volatility has been shown to be a mean reverting metric over time. Simply put, this means that if volatility is on the higher end, it is likely that it could move back to its lower mean sometime soon. Similarly, if volatility is on the lower end, it is likely that it could move back to its higher mean sometime soon. Of course, no one knows exactly when volatility mean reversion will occur, and we can never time these volatility contractions and expansions perfectly. But just knowing that volatility does exhibit a tendency to mean revert can give us more confidence in trading low volatility markets.

Debit strategy positioning

If volatility is low, and it does happen to expand, then any strategy that is long vega (i.e. long volatility) will benefit from that volatility expansion. Some of our favorite strategies here would be a diagonal spread, calendar spread, or long vertical spread. While the diagonal and calendar almost always benefit from volatility expansion, especially using a bearish bias on the put side, the long vertical could also benefit from volatility expansion. Therefore, any of these three strategies are great options for traders looking to stay active in low volatility markets and boost their occurrences.

Being debit trades on entry, each of these three strategies will benefit from rising option prices. And just like option prices fall when volatility contracts, option prices rise when volatility expands. Therefore, in a market with low volatility, given an empirical basis for volatility mean reversion, any of these three strategies are great options for traders looking to stay active in low volatility markets.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3

For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.

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