What Are You Trading—Direction, Volatility, or Correlation?
Tuesday, August 24, 2010 at 10:30AMWritten by Michael Bigger. Follow me on Twitter.
Let’s start with the first one. Let’s assume you are long in the market. It is pretty obvious that you are trading direction. But you could also be trading volatility.
Example: You decide to incorporate stop losses in your directional strategy. If the market sells off and your stops get hit, you sell. The same situation happens with your short positions if the market rallies into your stops. Your stop losses will trigger an unwinding of your short positions. You buy high and sell low. That is a typical short volatility trading profile.
Let’s take another situation. You are long and a massive bear market develops like it did in 2007–2008. You use no stops. With the market down 50% and your portfolio down 60 to 80%, you panic and sell some stocks. You bought high and sold low. In this situation, you are short volatility because of your sensitivity to a big negative market move.
Now let’s assume that the market is up 20% this year and your portfolio is flat. Your spouse asks you to explain the portfolio’s underperformance. If you take action to remedy the situation, you are trading correlation.
What are you trading?
Reader Comments (2)
If what I read is correct, you are saying that any trade one gets into can be seen as a volatility, direction, or correlational play. I agree with that - it is a matter of perspective. But I think hyour original trade idea/thesis is based on one of the three and as a trader you ought to stick to that perspective.
For instance, if I am long a bunch of calls becasue I believe that SPY will rise, I ought to trade that hypothesis and not switch halfway and say "Well, it seems like the market is not really moving but I think earning season is coming and so overall market IV will rise". Of course I may choose to trade off the bat a combo of volatility and direction in which case I suppose it would be OK to trade with that mindset - I personally wouldn't :) .
That is exactly my point. If you maintain the discipline, your are not influenced by the other factors. Not easy to do. It requires a great framework for achieving what you want to achieve. This is one of the reasons why it is so hard to manage other people's money. It tends to influence the process in ways you never anticipated. All of this....in my opinion.