I want to clarify a statement from my chat with John from Risk of Ruin.
I said “vol trading is easier than directional trading”.
This is something I’ve felt from experience. I long attributed it to derivatives pricing being, well, derivative of an underlying. Trading an ETF or index future, both derivatives, is “easier” in the sense that there is a fair value with respect to some assumptions like cost of carry but the variation in the assumptions is vanishingly small compared to the error bars on the assumptions one makes when formulating an opinion about a stock price.
For options, most of the inputs except volatility also have error bars that are far smaller than anything you’ll assume about a stock.
Which brings me to volatility.
Volatility is more stable than returns.* This is why quants target risk in their sizing, not returns.
See Know-Nothing Sizing for a fuller discussion. It’s an idea that underpins my approach to investing and risk management.
So if handicapping volatility is easier than handicapping returns, shouldn’t everyone just trade options for that sweet, easy cash?
The fact that it’s easier, also means the competition is fierce. It’s a zero-sum, capacity-constrained game. Predicting vol is easier than predicting returns, but…so what? You care about “how easy is it to make money?” and that is not easier.
The distinction reminds of this Daryl Morey bit on sport analytics:
Our underlying data is more predictive, quite a bit predictive. I talk to a lot of quants on Wall Street, and I tell them our signal to noise ratio using whatever measure you want….And they go like —whoa, you guys are — that’s incredible. And I’m like, yes, but you remember, we have to be best of 30. You guys just have to beat the S&P by 2% and you are geniuses. So each industry has its own challenges.
*For the option enjoyyyyers who are thinking “Bruh, VVIX is way higher than VIX, how can you say vol is less volatile than the vol of returns?”, here’s my rebuttal: What’s your 90% confidence interval on SP500 returns next year vs SP500 1-year realized vol?
An investor doesn’t care about vol of vol as if they are trying to price an option on VIX. If SPY realizes 14% give or take 5 points for a year (this is about the high/low range of 365 day vol using overlapping data for the past 4 years), this is not as destabilizing as the outright returns being say -5% vs +15% which is probably an even narrower relative range than 9% to 19% for a 1-year realized vol.
