The: New Technical Strategies for Investing in Unstable Markets Volatility Edge in Options Trading

by Jeff Augen

Overview

 “Jeff’s analysis is unique, at least among academic derivatives textbooks. I would definitely use this material in my derivatives class, as I believe students would benefit from analyzing the many dimensions of Jeff’s trading strategies. I especially found the material on trading the earnings cycle and discussion of how to insure against price jumps at known events very worthwhile.”

—DR. ROBERT JENNINGS, Professor of Finance, Indiana University Kelley School of Business

 

“This is not just another book about options trading. The author shares a plethora of knowledge based on 20 years of trading experience and study of the financial markets. Jeff explains the myriad of complexities about options in a manner that is insightful and easy to understand. Given the growth in the options and derivatives markets over the past five years, this book is required reading for any serious investor or anyone in the financial service industries.”

—MICHAEL P. O’HARE, Head of Mergers & Acquisitions, Oppenheimer & Co. Inc.

 

“Those in the know will find this book to be an excellent resource and practical guide with exciting new insights into investing and hedging with options.”

—JIM MEYER, Managing Director, Sasqua Field Capital Partners LLC

 

“Jeff has focused everything I knew about options pricing and more through a hyper-insightful lens! This book provides a unique and practical perspective about options trading that should be required reading for professional and individual investors.”

—ARTHUR TISI, Founder and CEO, EXA Infosystems; private investor and options trader

 

In The Volatility Edge in Options Trading, leading options trader Jeff Augen introduces breakthrough strategies for identifying subtle price distortions that arise from changes in market volatility. Drawing on more than a decade of never-before-published research, Augen provides new analytical techniques that every experienced options trader can use to study historical price changes, mitigate risk, limit market exposure, and structure mathematically sound high-return options positions. Augen bridges the gap between pricing theory mathematics and market realities, covering topics addressed in no other options trading book. He introduces new ways to exploit the rising volatility that precedes earnings releases; trade the monthly options expiration cycle; leverage put:call price parity disruptions; understand weekend and month-end effects on bid-ask spreads; and use options on the CBOE Volatility Index (VIX) as a portfolio hedge. Unlike conventional guides, The Volatility Edge in Options Trading doesn’t rely on oversimplified positional analyses: it fully reflects ongoing changes in the prices of underlying securities, market volatility, and time decay. What’s more, Augen shows how to build your own customized analytical toolset using low-cost desktop software and data sources: tools that can transform his state-of-the-art strategies into practical buy/sell guidance.

 

An options investment strategy that reflects the markets’ fundamental mathematical properties

Presents strategies for achieving superior returns in widely diverse market conditions

Adaptive trading: how to dynamically manage option positions, and why you must

Includes precise, proven metrics and rules for adjusting complex positions

Effectively trading the earnings and expiration cycles

Leverage price distortions related to earnings and impending options expirations

Building a state-of-the-art analytical infrastructure

Use standard desktop software and data sources to build world-class decision-making tools

Product Details

ISBN-13:	9780132703680
Publisher:	Pearson Education
Publication date:	01/17/2008
Sold by:	Barnes & Noble
Format:	eBook
Pages:	304
Sales rank:	545,025
File size:	5 MB

About the Author

JEFF AUGEN, currently a private investor and writer, has spent over a decade building a unique intellectual property portfolio of algorithms and software for technical analysis of derivatives prices. His work includes over one million lines of computer code refl ecting powerful new strategies for trading equity, index, and futures options. As co-founding executive of IBM’s Life Sciences Computing business, Augen defined a growth strategy resulting in $1.2B of new revenue and managed a large portfolio of venture capital investments. From 2002 to 2005, he was President and CEO of TurboWorx, Inc., a technical computing software company founded by the chairman of the Department of Computer Science at Yale University. He is author of Bioinformatics in the Post-Genomic Era: Genome, Transcriptome, Proteome, and Information-Based Medicine (Addison-Wesley, 2004).

 

Read an Excerpt

Betting With the HousePreface

This book is written for experienced equity and index option traders who are interested in exploring new technical strategies and analytical techniques. Many fine texts have been written on the subject, each targeted at a different level of technical proficiency. They range from overviews of basic options positions to graduate-level reviews of option pricing theory. Some focus on a single strategy, and others are broad-based. Not surprisingly, many fall into the "get rich quick" category. Generally speaking, books that focus on trading are light on pricing theory, and books that thoroughly cover pricing theory usually are not intended as a trading guide.

This book is designed to bridge the gap by marrying pricing theory to the realities of the market. Our discussion will include many topics not covered elsewhere:

• Strategies for trading the monthly options expiration cycle

• The effects of earnings announcements on options volatility and pricing

• The complex relationship between market drawdowns, volatility, and disruptions to put-call parity

• Weekend/end-of-month effects on bid-ask spreads and volatility

A cornerstone of our discussion will be a new set of analytical tools designed to classify equities according to their historic price-change behavior. I have successfully used these tools to trade accounts as small as $80,000 and as large as $20M.

Ten years ago, having studied the markets for some time, I believed I could be a part-time investor with a full-time professional career. At the time I was a computer-industry executive—a director at IBM—with a large compensation package and a promising future. My goal was to develop a successful trading strategy that could be implemented as an income supplement. It was a naïve idea. Successful investing is a demanding pursuit. The work described in this book took more than ten years. It involved writing hundreds of thousands of lines of computer code, constructing numerous financial-history databases, creating new data visualization tools, and, most important, executing more than 3,000 trades. During that time I also read dozens of books and thousands of technical articles on economic theory, technical analysis, and derivatives trading. The most important result was not the trading system itself, but the revelation that nothing short of full-time effort could possibly succeed. The financial industry is populated with bright, hard-working, well-educated professionals who devote every waking hour to making money. Moreover, there is virtually no limit to the funds that can be made available to hire outstanding talent. An amateur investor should not expect to compete with these professionals in his or her spare time. The market is a zero-sum game—every dollar won must also be lost. Option trading represents the winner-take-all version of the game. Consistently making money requires focus and dedication. That said, experienced private investors often have a distinct advantage over large institutions in the equity options world. The advantage relates to scale. A private investor trading electronically can instantly open or close typical positions consisting of tens or even hundreds of option contracts. Conversely, institutions often manage very large positions worth hundreds of millions of dollars. Efficient execution becomes a barrier at this level. Furthermore, many equity option issues do not have enough open interest to support trades of this size. The result is that institutional traders tend to focus on index options—which are much more liquid—and some of the more heavily traded equity options. Large positions take time to negotiate and price. They have an element of permanence because they can't be unwound with the press of a button. Liquidity and scaling are central to this work, and we will return to this discussion many times in the context of trading logistics.

Generally speaking, the work is not done—not even close. But I've come a long way. Today I can comfortably generate a return that would make any investment bank or hedge fund proud. Needless to say, I no longer work in the computer industry, and I have no interest in a salary. I'm free. My time belongs to me. I trade for a living.

© Copyright Pearson Education. All rights reserved.

Table of Contents

Acknowledgments . . . xi

About the Author . . . xii

Preface . . . xiii

A Guide for Readers . . . xv

1. Introduction . . . 1

Price Discovery and Market Stability . . . 6

Practical Limitations of Technical Charting . . . 9

Background and Terms . . . 12

Securing a Technical Edge . . . 16

Endnote  . . . 21

2. Fundamentals of Option Pricing . . . 23

Random Walks and Brownian Motion . . . 25

The Black-Scholes Pricing Model . . . 29

The Greeks: Delta, Gamma, Vega, Theta, and Rho . . . 32

Binomial Trees: An Alternative Pricing Model  . . . 42

Summary . . . 45

Further Reading  . . . 45

Endnotes . . . 46

3. Volatility . . . 47

Volatility and Standard Deviation . . . 48

Calculating Historical Volatility . . . 50

Profiling Price Change Behavior . . . 61

Summary . . . 75

Further Reading . . . 76

4. General Considerations . . . 77

Bid-Ask Spreads . . . 79

Volatility Swings . . . 82

Put-Call Parity Violations  . . . 89

Liquidity . . . 91

Summary . . . 95

Further Reading  . . . 97

Endnotes . . . 97

5. Managing Basic Option Positions . . . 99

Single-Sided Put and Call Positions . . . 100

Straddles and Strangles . . . 118

Covered Calls and Puts  . . . 137

Synthetic Stock . . . 143

Summary . . . 146

Further Reading . . . 148

Endnotes . . . 149

6. Managing Complex Positions . . . 151

Calendar and Diagonal Spreads . . . 152

Ratios . . . 162

Ratios That Span Multiple Expiration Dates . . . 175

Complex Multipart Trades . . . 182

Hedging with the VIX . . . 195

Summary . . . 202

Further Reading . . . 203

Endnotes . . . 204

7. Trading the Earnings Cycle . . . 205

Exploiting Earnings-Associated Rising Volatility . . . 207

Exploiting Post-Earnings Implied Volatility Collapse . . . 216

Summary . . . 222

Endnote . . . 223

8. Trading the Expiration Cycle . . . 225

The Final Trading Day . . . 226

The Days Preceding Expiration . . . 237

Summary . . . 240

Further Reading . . . 242

Endnotes . . . 242

9. Building a Toolset . . . 243

Some Notes on Data Visualization Tools . . . 245

Database Infrastructure Overview . . . 248

Data Mining . . . 252

Statistical Analysis Facility . . . 258

Trade Modeling Facility . . . 264

Summary . . . 268

Endnotes . . . 269

Index . . . 271