That was the question posed by Steve Meizinger in "Market Expectations and the Implications on Options Trader," the lead article in the Options Industry Council's Fall 09 newsletter. Long ago, I began advocating that the VIX, TRIN and even the advance/decline line could be studied using standard technical analysis tools. Meizinger's question caught my attention for that reason.
Of course volatility trends, I thought.
Annotated Weekly Chart of the VIX:
However, the application of such terms and technical analysis tools to the volatility indices isn't without controversy. Not all market watchers believe in such observations.
Even if one believes in applying standard technical analysis tools to the volatility indices, Meizinger makes the point that forecasting volatility proves difficult. Traditional forecasts of option volatility often depend on the idea that implied volatility, the spot estimate of an underlying's future volatility, will revert to the mean. That mean is the historical volatility over a certain period of time, such as 30 days or six months or a year, whatever the observer's preference. Although my explanation is a bit simplistic, I relate this to the assumption that equity prices that have jumped too far above or fallen too far below their 30-day simple moving average may be getting a bit overdone to the upside or downside and may reverse course to test that 30-sma again.
The difficulty with that assumption, Meizinger points out, is that one that we often see with equity prices. That promised "reversion to the mean" is neither a promise nor a good market-timing tool. Yet, even if we're not Nostradamus, options traders must make observations and formulate theses, adjusting their strategies accordingly if their theses prove either right or wrong. For example, a trader who refuses to trade anything but calendars, a vega-positive trade that benefits from a climb in volatility, might find her profit-loss graphs showing no possibility of profit if volatilities collapse more than she thought was likely. If volatilities keep trending lower and she persists in her calendars-only trades, her trading account might suffer. Meanwhile, her butterfly or iron-condor trading friends might be celebrating the trending-lower volatilities. Those same trending-lower volatilities produce quicker profits for them.
Meizinger advocates taking the path that I've been attempting to follow for the last several years: learning as much about as many different options strategies as is possible. I am a person who prefers trading one type of strategy in one underlying, but that's never a good idea. It's akin to having all one's portfolio tied up in a single stock. I've been attempting to wean myself away from this tendency. I advocate a balance of well-understood strategies on a few underlyings, however, not a hopping-about from strategy to strategy across the spectrum of underlyings, based on one's prediction for volatility and price changes. You won't find me doing a GOOG earnings trade one month with 30 percent of my trading capital, a giant IBM iron condor another, and a third strategy on a stock I found through a scan on another month.
Familiarity with several strategies and a deep understanding of how several underlyings move can allow a trader to vary the mix of familiar and tested trades in a portfolio. In the Trader's Corner articles over the past couple of weeks, I've examined some cases when the VIX seems to outstrip the normally more volatile VXN. The possibility exists that such cases sometimes suggest a reversal in both volatility indices and a resultant reversal the other direction in equities. Perhaps if I should notice an imminent reversal through a comparison of the VIX and VXN and should concurrently notice that the VIX had broken through a rising trendline's support, I might develop a thesis that these volatility indices appear ready to reverse. On the theory that it's possible--not a given--that volatilities might decrease, I might overweight a portfolio with vega-negative trades such butterflies and iron condors on the usual underlyings that I trade and underweight it with vega-positive trades such as long options or calendars on the usual underlyings that I use for those strategies.
Why not just employ all vega-negative trades under those conditions? If I were Nostradamus, maybe I would. However, we're all familiar with the saying that markets can stay overbought (or oversold) longer than we can stay solvent. There's that whole reversion-to-the-mean thing that can take longer than expected. Overdone moves can continue longer than we expect them to continue. Meizinger argues that volatility measures can do the same. A mix of strategies spreads risk, although that mix might be altered according to one's market and volatility outlook. "Options traders must be continually flexible in their options strategies," Meizinger advises (5).
I wouldn't argue. My advice is, as it's always been in recent years, to watch volatility measures using standard technical analysis tools. Increasingly over the last several years, I've been convinced of the importance of broadening one's repertoire of options-trading strategies via research, paper or simulated trades, and then small trades in one-contract sizes. Then, as we notice particular setups in the volatility measures, we can decide how we want to balance the vega-positive and -negative trades in our portfolios. I'm not there yet. I'm still busy building my repertoire sufficiently so that I feel comfortable switching from a portfolio that has more iron condors than anything else to one that more evenly balances the risks. And then, depending on the volatility outlook, rebalances them again.