Written 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?