In our view, the Efficient Market Hypothesis isn’t true, but it is close to being true. It is very hard to beat the market. In any competition it pays to analyze the opponent.  So, to beat the market you need to know the market’s weaknesses. Where are some niches that you can possibly exploit?

Volatility markets, while still very efficient, are a lot less efficient than equity markets. There are a few reasons for this. First, it is often hard to monetize any forecast. Trading and dynamically hedging options is time consuming, costly and requires a significant investment in education. Even then it is possible to make a correct forecast and lose money due to the path dependency of a hedged option position. But another reason is that most professional traders don’t do a lot of volatility forecasting. It just isn’t the game they are playing.

Almost all professionals trade options on a relative basis. This minimizes both the risk that their pricing models are wrong (they will be) and that the volatility is unknown. Market makers know that if the 100 call has an implied volatility of 30%, then the 105 calls should have an implied volatility of about 29%. They make their prices on the basis of these relative relationships and manage their risk by spreading off options against each other. They never know (or much care) whether the 100 call should have a volatility of 30% or not. It isn’t that important most of the time.

Exotics traders do much the same thing. They take the values of the vanilla puts and calls and use these to calibrate their models. So the price of a particular exotic is contingent on the prices of the vanillas. And if they trade the exotic, they will spread off as much of the risk as possible in the vanilla options.

(This is the plan. The plan doesn’t always work. Just as a bookmaker wants to balance the action and have no interest in the outcome of a game, a market maker (or exotic trader, or sales trader or facilitation desk… practically all institutional traders are liquidity providers) would like to have low volatility risk. But flow is never perfectly balanced and market makers will end up with inventory and hence volatility risk.  It is at this point that their thoughts turn towards figuring out what volatility really should be. This isn’t completely irrational. Most traders are making markets in tens or hundreds of underlyings. They don’t really have time to do individual forecasts unless they are in a situation when they really need one.)

This approach won’t work for retail traders or most buy side institutions. It requires a lot of infrastructure investment and exchange memberships. But if the people who are most involved with options aren’t generally forecasting volatility, it is possible for outsiders to do so and profitably trade against the market.

Most professional poker players know that the secret to success is to find a good game. Similarly, in the trading world it is better to first look for a possible weakness in the market than to try to beat highly efficient markets. Obviously you still need to do the actual work of forecasting, but volatility is also quite predictable for a financial parameter. There are literally thousands of papers on how to do so (and if anyone says nothing good is ever published it is more of a reflection on their reading and comprehension skills than the quality of published research). Making a good forecast isn’t easy, but it is possible, and it can be profitable.