The cornerstone of Modern Portfolio Theory is that Volatility Equals Risk. A similar concept exists in Pre-Modern Investment Theory: Safety Through Diversity. In the Pre-Modern example, diversification of assets leads to lower volatility by diluting outliers in the return distribution.
In speculative trading, volatility more often than not equals safety. For Day Traders picking stocks on hunches, a high volatility environment offers more chances to exit at breakeven or a profit than a low volatility environment. To less sophisticated traders, the extra chances to get out offer the illusion of profitability. This is why Day Trading Shops thrive in high volatility environments like 1999, and fade in low volatility environments like 2009-2014. During high volatility environments, the Day Trading Dream is usually shattered when a single loss wipes out all of the previous gains, sometimes even the entire account. This process may take weeks or months to unfold. In low volatility environments, the Dream is shattered on the first bad trade.
To the sophisticated options trader, Volatility Equals Safety. Unlike the Day Trader, the experienced options trader has many tools to control risk and extract maximum profit from gyrating markets. To do this, controlling the Position Size is critical. Two important components of position size are first, the total size of the position entered and second, the number of trades used to get into (and out of) the target quantity. For a position size of +10 contracts, a trader might enter using 5 trades of +2 contracts, at 5 different strikes. This limits the risk exposure at any single strike and also allows tactical readjustments midstream if market conditions change. If a position shows high profit after the first two trades get filled, astute traders may decide to take profits right away and not “chase” the remaining contracts after a big move.
A good rule of thumb is to size each trade at a microscopic pain level. This insures that in psychologically difficult trades, such as fading a flight to quality in the bond market, or shorting a spike in volatility, the trader can stick to the program and add additional units of risk when the position goes negative.
When trading volatile, mean-reverting markets, this difficult period is usually the best time of all to put more risk into the portfolio.
David A. Janello, PhD, CFA