Option Trading: Pricing and Volatility Strategies and Techniques

by Euan Sinclair

Overview

Successful trading, in general, is difficult and options specifically can be compli-cated. In most cases, those who do well have an ability to focus on good processes and let the results take care of themselves.

Nobody is more familiar with this situation than professional trader and quantitative analyst Euan Sinclair. In Option Trading, he's broken down the process into the parts you need to thrive—an understanding of market structure, knowledge of the instruments you trade, a way to capture an edge, and a methodology for managing risk.

Written with the serious trader in mind, this comprehensive guide opens by exploring options, both historically and conceptually, and then uses the no-arbitrage principle to introduce option pricing—examining both static arbitrage relationships and the dynamic hedging approach. With this critical background in hand, the largest and most substantial part of the book addresses how to actually trade options.

Along the way, you'll gain an in-depth understanding of:

• The various option strategies that can be implemented, from puts and calls to strangles, straddles, and butterflies
• How to measure and forecast realized volatility, the nature and behavior of implied volatility, and what it takes to successfully trade the two
• The concept of expected value, the general idea of hedging, and the importance of trade sizing
• The strategies behind market making
• The essential aspects of risk management in option trading
• And much more

Option trading is an important part of the financial landscape. This book will show you how to make the most of these profitable products, no matter what the market does.

Product Details

ISBN-13:	9780470642528
Publisher:	Wiley
Publication date:	07/16/2010
Series:	Wiley Trading , #445
Sold by:	JOHN WILEY & SONS
Format:	eBook
Pages:	320
Sales rank:	271,547
File size:	3 MB

About the Author

EUAN SINCLAIR is an option trader with fifteen years of professional trading experience. He specializes in the design and implementation of quantitative trading strategies. Sinclair is currently a proprietary option trader for Bluefin Trading, where he trades based on quantitative models of his own design. He holds a PhD in theoretical physics from the University of Bristol. Sinclair is also the author of the Wiley title Volatility Trading.

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Table of Contents

Preface xi

Professional Trading xii

The Role of Mathematics xiv

The Structure of this Book xvi

Acknowledgments xix

CHAPTER 1 History 1

Summary 6

CHAPTER 2 Introduction to Options 7

Options 9

Specifications for an Option Contract 9

Uses of Options 11

Market Structure 14

Summary 20

CHAPTER 3 Arbitrage Bounds for Option Prices 21

American Options Compared to European Options 25

Absolute Maximum and Minimum Values 25

Summary 39

CHAPTER 4 Pricing Models 41

General Modeling Principles 42

Choice of Dependent Variables 45

The Binomial Model 48

The Black-Scholes-Merton (BSM) Model 55

Summary 61

CHAPTER 5 The Solution of theBlack-Scholes-Merton (BSM) Equation 63

Delta 67

Gamma 72

Theta 76

Vega 80

Summary 88

CHAPTER 6 Option Strategies 89

Forecasting and Strategy Selection 89

The Strategies 93

Summary 116

CHAPTER 7 Volatility Estimation 117

Defining and Measuring Volatility 119

Forecasting Volatility 129

Volatility in Context 132

Summary 136

CHAPTER 8 Implied Volatility 137

The Implied Volatility Curve 138

Parameterizing and Measuring the Implied Volatility Curve 142

The Implied Volatility Curve as a Function of Expiration 145

Implied Volatility Dynamics 146

Summary 151

CHAPTER 9 General Principles of Trading and Hedging 153

Edge 154

Hedging 156

Trade Sizing and Leverage 158

Scalability and Breadth 163

Summary 164

CHAPTER 10 Market Making Techniques 165

Market Structure 166

Market Making 169

Trading Based on Order-Book Information 181

Summary 189

CHAPTER 11 Volatility Trading 191

Hedging 192

Hedging in Practice 193

The P/L Distribution of Hedged Option Positions 203

Summary 213

CHAPTER 12 Expiration Trading 215

Pinning 215

Pin Risk 219

Forward Risk 221

Exercising the Wrong Options 221

Irrelevance of the Greeks 223

Expiring at a Short Strike 224

Summary 225

CHAPTER 13 Risk Management 227

Example of Position Repair 228

Inventory 232

Delta 234

Gamma 234

Vega 238

Correlation 240

Rho 242

Stock Risk: Dividends and Buy-in Risk 242

The Early Exercise of Options 243

Summary 248

Conclusion 249

APPENDIX A Distributions 253

Example 253

Moments and the “Shape” of Distributions 254

APPENDIX B Correlation 263

Glossary 271

Index 285