The Value of Alternating Trading Approaches between Directional and Neutral

The first thing a trader should do before initiating a position is to take the temperature of the market by measuring volatility. Volatility is a mathematical measure of the emotional condition of a market. Just as a person goes through mood swings, so does every market.

When emotions heat up in the stock market, you see wide swings in prices and the difference in the daily high and low begins to get large. Statistical volatility measures the magnitude of these price swings. Likewise, when emotions get highly charged in the options markets, option premiums expand. Implied volatility measures how expensive these premiums are.

The key thing to remember about this is when emotions go to extreme levels; it’s just a matter of time before they revert back to normal. There is a way to mathematically capitalize on this “law of nature” so that over the long term, you trade with the odds in your favor.

Making trading decisions based on the emotional condition of the market is a lot different than guessing market direction. The difference is the difference between being a volatility trader and being a directional trader. Volatility traders use probability and the mathematical properties of options to decide what stocks they should focus on and to select the options they should trade. Volatility traders are neutral traders because they initiate spread trades in options that are “Delta Neutral” and they adjust their positions when they become biased long or short.

The very first decision traders must make is whether they will be a volatility trader who will trade options dynamically, or whether they are choosing to anticipate market direction. Most traders fall into the directional category because they don’t even know an alternative exists. At the very minimum, allocating a portion of risk capital to this volatility approach will help the equity curve. Diversification typically reduces variability of returns, which is always a good goal.

Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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