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Compression

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If you look at any price chart of any security, notice that often times a volatile move is preceded by a period of churning, a tight trading range with low volatility. The longer and tighter this period of "compression", the more violent the moves out of it.

This compression and subsequent pop out of such a trading range is the result of traders/investors losing an understanding of risk control.

In periods of low volatility, such as what we have had, traders and investors come under increasing pressure to make money. They begin to do stupid things to "try" to make money, stupid things like we have been describing like selling options too cheaply to "earn some income". Selling options cheaply increases gamma and causes moves to be larger than they otherwise would be.

A similar and more important phenomenon, because it is so much larger, is the sizing of positions. Let's say a trader wants to risk a certain amount being short a stock. Because she is under increasing pressure to make money and because the market is less volatile, she instead of shorting 10,000 shares decides to short 20,000. This of course multiplied by thousands of traders is a symptom of compression: everyone over time becoming bigger than they should be and consequently have too much risk.

When the market begins to move, as it inevitably will, these traders find themselves losing too much money and cover. This exacerbates the moves, which feeds on itself, and creates a pocket of volatility as the traders struggle to balance their risk back to appropriate levels.

This further illustrates the ultimate importance of understanding and controlling risk as the defining element in trading.
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No positions in stocks mentioned.

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