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Volatility and Market Direction


Normally markets become less volatile as they rise, so people automatically make this assumption that it is always so. But understanding the reasons why this occurs will help identify the times that it does not.

As discussed in several pieces on index options, which describes the effect of correlation on option prices, the way stocks trade against each other has a huge effect on volatility.

Stock risk can be divided into two parts: systematic risk and unsystematic risk. Systematic risk affects all stocks and is normally macro in nature. When systematic risk increases, all stocks normally go down; a by product of that is that the correlation between stocks increases. It is this increase in correlation that actually causes the increase in volatility.

Since increased systematic risk normally causes stocks to go down and correlation to go up (increased volatility), people forget about the why and just associate declining markets with higher volatility.

But there are situations where the systematic risk can increase and stocks can go up, although these are probably very limited and short experiences. This could be one of those times.

With stocks up this morning off of current earnings reports and geopolitical risk still high or even higher (at least to me), I believe that markets can be even more volatile.

I will use any decline in option prices to selectively buy convexity.
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No positions in stocks mentioned.

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