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Options: Questioning IV, A New Look At The Definition Of Trading Risk

Here are some new ways of thinking about investment risk: "Conservative" can mean different things to different people; so here is a definition that challenges popular thinking, in which risk is strategy-specific: Any low-risk investment with above-market average return is a Conservative Investment.

Risk usually is thought of in terms of specific products, especially when it came to options. For example, a covered call is conservative but an uncovered call is high-risk. A long option is low-risk and a short option is always high-risk.

These widely applied generalizations should be challenged. Why? Because risk is not based on the attributes of the strategy, but on timing and placement. So for options, for example, it is not enough to stick with a specific strategy. You need to look at a broad range of attributes including historical volatility and even fundamental volatility(especially in key fundamentals including a 10-year history of dividends, P/E ratio, revenues and earnings, and the debt capitalization ratio). The argument here is that strong fundamentals migrate to strong technicals and lower-risk trades.

In articulating "risk" for options trades, volatility can be visualized on a stock chart by simple observation. The widespread belief in implied volatility is misplaced, because it does not truly predict future price behavior. It is simply an estimate based on the current market price of the underlying and related options.

Many option traders adhere to the belief that volatility leads price, when the opposite is true. Volatility is a reflection of price behavior. One study concluded that there is no evidence whatsoever to support the belief the volatility will affect future price. (Bouchard, Jean-Philippe and Marc Potters (2009), Theory of Financial Risk and Derivative Pricing: From Statistical Physics to Risk Management, 2nd ed. Cambridge UK: Cambridge University Press).

Thus, the popular definition of option risk found in analysis of implied volatility relies on estimates without basis. Traders can see volatility on stock charts in the price range itself, and especially with reliance on strong technical signals like Bollinger Bands, which sets up a "probability matrix" and dynamic resistance and support. Spotting trading behavior, especially as it moves above or below the Bollinger bands, is a more reliable timing mechanism than implied volatility.

Because timing and placement of a trade defines risk, reliance on these technical signals is more likely to improve timing, and can redefine "risk" for options trading. Rather than classifying specific strategies as high-risk or low-risk, spotting the levels of volatility on the chart of the underlying is a reliable method that contradicts popular thinking about volatility itself, and challenges the mistaken belief that volatility leads price.

Michael Thomsett blogs at TheStreet.com, Seeking Alpha, and several other sites. He has been trading options for 35 years. He also teaches on the Candlestick Forum website. To check membership, go to Candlestick Forum membership. His new book can be viewed at tinyurl.com/z44kzlu