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Here is how to calculate a two standard deviation move in bonds. We will assume bonds
are trading at 110 and their 100-day historical volatility is at 10 percent.
10% H.V./Square Root of 265 trading days = .6250%
.6250% x 110.00 (bond price) = .6875, or 22/32
22/32 x 2 (Standard Deviation) = 1.375, or 1 12/32
110.00 + 1 12/32 = 111 12/32
110-1 12/32 = 108 20/32
Table 1. Calculating a two standard deviation move T-bonds.
Now, let's apply this to the real world. It's human nature to get caught up in the
hype and trade in the direction of the move. Worse, many traders are inclined to
do so with options. Unfortunately, these options will be grossly overpriced
because of the increase in implied volatility caused by traders' excitement over
the move. Not only is there a high likelihood the move won't continue (causing
time erosion in the options' value), but even worse, you are buying overvalued
options! You have the worst of all worlds.
The smarter strategy is to sell the overpriced options via a naked combination.
You can sell calls that are one standard deviation from the large-range day's high
and the puts that are one standard deviation from the large-range day's low. If
the market moves sideways the premiums on both sides will collapse. (A word of
warning: In strongly trending markets (ADX 25 or higher), this principle does not
hold true. Our research has found it works best in non-trending markets.)
In conclusion, when markets move two standard deviations from their normal
volatility, the reversion to the mean principle will kick in and the market probably
will take a few days to rest. As a result, markets tend to move sideways rather
than further in the direction of a large-range day. Such situations are good
opportunities to sell overpriced options and benefit from imploding volatility.