(This is an excerpt from my upcoming book on positional option trading.) The traders’ concept of the Efficient Market Hypothesis (EMH) is, “making money is hard”. This isn’t wrong, but it is worth looking at the theory in more detail. Traders are trying to make money from the exceptions to the EMH, and the different types of inefficiencies should be understood, and hence traded, differently. The EMH was contemporaneously developed from two distinct directions. Paul Samuelson (Samuelson, 1965) introduced the idea to the economics community under the umbrella of “rational expectations theory”. At the same time, Eugene Fama’s studies (Fama, 1965 a and b) of the statistics of security returns lead him to the theory of “the random walk”. The idea can be stated in many ways, but a simple, general expression is: A market is efficient with respect to some information if it is impossible to profitably trade based on that information. And the “profitable trades” are risk adjuste
To be able to trade volatility we need to understand it, particularly the interplay between clustering and mean reversion. Most of the predictability of volatility is due to one of these two features.