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Watch out for 'abnormal high volatility'

Normal high volatility is where we understand what's going on, even though stock prices are usually getting hammered.

For example, the banking sector crash in 2007/08. We might not have known all the details but we understood the basics of why the market was getting crushed and why option volatility was so high.

Abnormal high volatility is where the markets are slumping but:

a) We don't understand what's happening, and
b) The event causing the mayhem hasn't happened before

Two examples of abnormal high volatility -

The stockmarket crash of 1987 - Yes, the market had crashed before in 1929 but that was a long time ago. The 20% decline in stock prices that day meant that no one properly understood what was going on, nor what might happen. For example, there were plenty of rumours that the majority of banks and brokerage houses were effectively bust.

The September 11th 2001 New York attacks - Again, who knew what was happening? And how many outrageous rumours were there going around? But were the rumours so outrageous and unbelievable versus what had happened earlier in the day to the Twin Towers?

Another example of abnormal high volatility might be a civil war in an important country. What would happen to the markets if this happened in Saudi Arabia?

Why abnormal volatility should be avoided

When there's normal high volatility it's not a problem for an experienced options trader to short volatility via selling option premium. He'll have enough market savvy to be able to get himself out of too much trouble if the trades go against him.

But with abnormal high volatility who knows a) what's going on and perhaps more importantly b) what is likely to happen. Therefore it's an extremely dangerous trade to start shorting option premium whereas staying out of the option markets altogether is the best trade.

Summary - When strange events are happening, such as ones with little or no historical context, it's not worth getting involved with options. The volatility will be too high and it will be too easy to lose money.

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