Why Stock Traders Should Monitor Volatility Like an Option Trader

11/10/2010 12:01 am EST

Focus: STRATEGIES

While many are quick to point out the prominent position that volatility analysis should hold in an option trader’s bag of tricks, stock traders can also benefit from an increased understanding of volatility. It could be said that a stock goes through alternating periods of volatility expansion and compression. Though this assertion may not seem revolutionary, or even that revealing to those in familiar territory, traders may find it enlightening when viewing price movement through this lens.

Consider the recent activity in the financial sector, for instance. The consolidation experienced through much of the last two months was merely a compression in volatility, a coiled spring of sorts, which served as a precursor to last week’s expansion. Understanding that compressions don’t continue in perpetuity, but instead give rise to some type of expansion, can aid in identifying appropriate entries for not only long volatility strategies, but also directional plays.

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The trick, as with virtually any trading approach, lies in the timing. This is especially true when using options, as time decay can whittle away at your position while waiting for the breakout to transpire. It can be aggravating when purchasing straddles in anticipation of a volatility expansion only to see the stock taunt you with yet more consolidation. Given the magnitude of the breakout in the financial sector this go around, it’s a good bet those who were positioned for the expansion received some justly deserved spoils of war.

By Tyler Craig of TylersTrading.com

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