Positional Option Trading (Wiley Trading)
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Implied skewness premium, 46–47
Implied variance premium, 40–42
Implied volatility, 36, 46–47, 61–62, 76, 123, 133
asymmetric implied volatility skew, 191
example, 140t
skew, 102–104, 103t
Implied volatility surface, 7f
Index options, 78
Index restructuring, 177–178
Index variance swaps, sale, 47
Industry beta, 82
Inefficiencies, trader profit, 14–15
Inefficiency-based strategy, half-life, 15
Inflation, examples, 171–172
Information, 13–14, 70
Information, price implications (agreement), 13
In-sample data sets, usage, 23
251
Interest rates, 183–186
Interpolation, usage, 34–35
Intuition, 30, 36
Investment ratio, change effect (quantification), 160
Investors, overconfidence/overreaction, 69–70, 81
J
Japanese candlesticks, 22
Jump risk, 52
K
Kelly control/criterion, 147–149, 158–161, 167–169, 169t
Kelly ratio, 127, 155, 160f, 161f
Knowledge, classification, 30
Know your customer (KYC) due diligence, 173
L
Liquidity providers, opportunities, 53
Long call, 54, 55f, 127, 129–131
Long-dated futures, expense, 61
Long option, usage, 54
Long stock, 128, 133
Long straddle strategy, results, 72f
Long-term growth rate (maximization), Kelly criterion (usage),
147–148
Long volatility positions profits, increase, 66–67
Loss aversion/size, 19, 71, 72
Losses (limitation), stops (usage), 165
M
252
Market, 12, 16, 20, 52–53, 64
impact (total cost component), 200
risk, reduction, 77
Mean reversion, allowance, 34
Mean-reverting strategy, usage, 58
Mean, weighted three-point estimate, 196
Median final underlying price, 119
Meta risks, 171
Mid-market prices, usage, 72
Mispriced short straddle, returns (summary statistics), 89t
Model-driven forecasting, 30–33
Model-free directional trading, 114
Model-free volatility trading, 4
Modified BSM model, performance (comparison), 192
Momentum, behavioral roots, 67
Money put options, sell-out, 133
Monte Carlo simulation, usage, 104
Mutual funds, performance, 26
N
NASDAQ 100, variance premia, 44, 44f
Nikkei, drop, 174–175
No-good-deal theory (Cerny/Hodges), 189
Noise traders, 13, 18
Nonconstant volatility, 190–192
Non-farm Payroll report, PPI release, 76
Non-normality, 149
Non-normal outcomes, 149–154
Non-normal return distribution, creation, 190–191
Normal backwardation, theory, 62
253
Notional exposure, maintenance, 59
O
Occurrence rate, upper bound, 197
Offshoring, impact, 15
Opportunity cost (total cost component), 200
Option pricing models, 1, 4, 5
Options, 3–10, 101f, 106t, 109, 113–118, 157f, 157t
factors/dependencies, 63–68, 189
hedging, imperfectly correlated underlying (inclusion), 190f
non-redundancy, 52
premia, ignoring, 107
pricing inputs, range estimates (conversion), 195–196
real options, financial options (distinctions), 188–189
returns, distribution (summary statistics), 118–120
risk-neutral option prices, subjective option prices
(comparison), 117t
value, factors, 188
Orders, fill-price, 202
OTM calls/puts, 102, 130
Outperformance, determination, 24
Over-betting, 155, 158t
Overconfidence, 18
Overnight effect, 75
Overnight returns, volatility (reduction), 75
Overoptimism, 19
P
Patterns, subjectivity, 22
Percentage-based trailing stop, usage, 168
Peso problem, 55–56
254
P/L, 54, 130, 141
dispersion, reduction, 100
standard deviation, 190f
terminal distributions, 85
PL distribution, 8, 9f, 100t, 102t, 128f
Poorly priced butterfly, profit distribution, 96f
Poorly priced condor, profit distribution, 97f
Poorly priced short strangle, returns (summary statistics), 90t
Portfolios, 64–67
Post-earnings announcement drift (PEAD), 21, 68–75, 82
PPI announcement, impact, 50
Pre-BSM pricing models, usage, 115
Pre-earnings announcement drift, 81–82
Pre-earnings anomalies, 82
Pre-earnings long straddles, profitability, 74
Price changes (total cost component), 200
Price-to-book (P/B) ratio, 63, 64, 66
Price-to-cash flow (P/CF) ratio, 63, 65
Price-to-earnings (P/E) straddle trading results, 64
Profitable trades, risk adjustment, 12
ProShares Ultra VIX short-term futures ETF (UVXY), 178, 201t,
202–203
Psychological explanations, problem, 17
Purchasing power parity, 58
Puts, 102, 105t, 133, 144t
put-call parity, 95, 116
put-call relationship, 115
short put, 55f, 127, 131, 137–138, 141t
p-value, defining, 24
255
Q
Quarter Kelly, full Kelly (trading comparison), 169t
R
Range estimates, conversion, 195–196
Rational expectations hypothesis, 41
Rational expectations theory, 12, 41
Ratio spreads, 142–145
Realized skewness, 47
Realized volatility, 86, 103f, 103t, 123t, 124t, 140t
Real options, 188–189
Return on asset (RoA)/return on equity (RoE) straddle trading
results, 65
Return paths, 53f, 54f
Returns, 24, 53–55, 95, 118–120, 162f
Risk, 52–53, 117t, 118, 161, 171–179
factor, 26
ratios, 127–128
reduction, cost, 101
reversal, 127, 138–143, 139f, 139t, 140t, 141t
slide, 144t
volatility risk premia, volatility, 78–80
Rolling 30-day close-to-close volatility, 34f
Rule of five/rule of three, 196–198
Russell 2000, variance premia, 44, 44f
S
Sampling, 24, 157–158
Second-month implied volatility, 102t
Second-month volatility, 101
Self-attribution bias, 19
256
Selling volatility, positive expected value, 88–89
Shares, stock price (summary statistics), 128t
Sharpe ratio, 47, 121–122, 127
Short-dated futures, expense, 61
Shorter-dated options, hedges (comparison), 108
Short front-month straddle, PL distribution (summary statistics),
100t, 102t
Shorting ability, 187–190
Short option volability indices (CBOE), 45
Short put, 55f, 127, 131, 137–138
Short sales proceeds, risk-free rate investment, 6
Short straddle, 73f, 87f, 94f
Short s
traddle returns, 87t, 89f, 89t, 91t
Short strangle, 88f
Short strangle returns, 88t, 90f, 90t, 91t
Short-term thinking, 19
Short volatility products, popularity, 59–60
Single 241 put, risk slide, 144t
Situational forecasting, 30–33
Sizing fraction, variance, 156
Skew, 46–47, 141–143, 191
Skewness, 141, 153, 154f
Smart beta factors, risk/behavioral reasons, 68t
Spread bet arbitrage, usage, 178
Spread payment, requirement, 202
SPY, 7f, 35, 35f, 104, 105t, 107t
Standard & Poor's 100 (S&P100), 63–64
257
Standard & Poor's 500 (S&P500), 29, 37t, 79, 133, 134t
options, 47, 110
realized volatility, VIX (impact), 42f
returns, 91, 92f, 99t
variance premium, 43f, 43t
volatility EWMA forecast, 38t
Standard & Poor's (S&P) GSCI Commodity Index, 58
Stocks, 25–26, 51t, 55f
dividend payments, absence, 186
returns (prediction), high-variance premium (usage), 136
Stops, 161–169, 162f, 163f, 164f
Straddles, 64–66, 86–93, 93t, 94t, 95f, 100, 100t, 101f, 102t
Strangles, 86–93, 88f, 88t, 93t, 94t, 103f, 103t, 107t
Strawman arguments, usage, 148
Strikes, 104–109, 118f, 120–124, 120f, 123t, 124t, 131, 133
Subjective option prices, risk-neutral option prices (comparison),
117t
Subjective option pricing, 113–118
Subjective technical analysis, 22
T
Taxes, absence, 186–187
Technical analysis, 13, 21–25
Terminal PL distribution, 8f, 9f
Term structure, 7, 42f, 62
Theft, impact, 173–174
Thesis/antithesis/synthesis, 18
Theta, 6, 77
Three-point estimators, 195
Time series analysis, 67
258
Time until expiration, 4
Time-varying crash risk factor, risk premums, 79
Total cost, components, 200
Traders, 17, 133, 182
Trades, 25, 32–33, 147
execution, 199, 204–205
location, positive expected value, 57
profitability, 71, 72
risk, stops (usage), 165
simulation (return distribution), trailing stop (usage), 164f
Trading, 52, 80–81, 187–190
opportunities, classification, 31
results, skewness level, 158t
statistical rules of thumb, 195
strategy, return distribution, 162f
Trailing stop, 164, 168
Transaction costs, absence, 13
Trend-following, 58
Trend lines, 22
Two-option hedge, expense, 108–109
U
Uncertain parameters, 154–158
Uncertainty premiums, risk premiums, 79–80
Uncertainty, signifiers, 74
Underlying, 6, 187–190
Underlying price/strike, 4
Unhedged option, return, 115
V
259
Variance premium, 39, 44f
commodity sectors, correlation, 49t
equity indices usage, 42–46
implied variance premium, 40–42
reasons, 51
size/significance (commodity options), 48t
S&P500 variance premium, 43f
Variance swaps, 50, 51t
Vega, 6, 86, 95, 95f, 101, 144
vega per option, 104
Volatility, 4–9, 34f, 76–80, 103f, 103t, 190–192
arbitrage model, 32
decrease, 34
delta-neutral volatility strategies, profitability, 70–71
explosions, 30
forecasting, 29, 35f
positions, 85
prediction, 143
premium, 4, 135, 136f
shorting, 143
uncertainty, 79
Volatility Index (VIX), 25, 39–41, 41f, 42f, 50, 62
action, prediction, 32
construction, 36
creation/tradability, 16
ETNs, 59, 60
front-month VIX future, sale (profit), 40f, 42f
initiation, 16
sorting, summary statistics, 44t
260
Volatility Index of Volatility Index (VVIX), 78–80
Volume-weighted average price (VWAP), 199, 203, 204
VXX (volatility ETN), 59
W
Weekend effect, 77–78
Weekend returns, establishment, 78
White's reality check (WRC), 23, 24
Windowing effect, 33
Win potential, 141
Win size, example, 71, 72
Y
Year-over-year earnings, focus, 69
Z
Zero size price, 202
261
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Document Outline
COVER
INTRODUCTION Trading as a Process
Summary
CHAPTER 1: Options Option Pricing Models
Option Trading Theory
Conclusion
Summary
CHAPTER 2: The Efficient Market Hypothesis and Its Limitations The Efficient Market Hypothesis
Aside: Alpha Decay
Behavioral Finance
High-Level Approaches: Technical Analysis and Fundamental Analysis
Conclusion
Summary
CHAPTER 3: Forecasting Volatility Model-Driven Forecasting and Situational Forecasting
The GARCH Family and Trading
Implied Volatility as a Predictor
Ensemble Predictions
Conclusion
Summary
CHAPTER 4: The Variance Premium Aside: The Implied Variance Premium
Variance Premium in Equity Indices
The Implied Skewness Premium
The Implied Correlation Premium
Commodities
Bonds
The VIX
Currencies
Equities
Reasons for the Variance Premium
Insurance
Jump Risk
Trading Restrictions
Market-Maker Inventory Risk
Path Dependency of Returns
The Problem of the Peso Problem
Conclusion
Summary
CHAPTER 5: Finding Trades with Positive Expected Value Aside: Crowding
Trading Strategies
Options and Fundamental Factors
Post-Earnings Announcement Drift (PEAD)
Confidence Level Two
The Overnight Effect
FOMC and Volatility
The Weekend Effect
Volatility of Volatility Risk Premia
Confidence Level One
Earnings-Induced Reversals
Pre-Earnings Announcement Drift
Conclusion
Summary
CHAPTER 6: Volatility Positions Aside: Adjustment and Position “Repair”
Straddles and Strangles
Aside: Delta-Hedged Positions
Butterflies and Condors
Aside: Broken Wing Butterflies and Condors
Calendar Spread
Including Implied Volatility Skew
Strike Choice
Choosing a Hedging Strike
Expiration Choice
Conclusion
Summary
CHAPTER 7: Directional Option Trading Subjective Option Pricing
A Theory of Subjective Option Pricing
Distribution of Option Returns: Summary Statistics
Fundamental Considerations
Conclusion
Summary
CHAPTER 8: Directional Option Strategy Selection Long Stock
Long Call
Long Call Spread
Short Put
Covered Calls
Components of Covered Call Profits
Covered Calls and Fundamentals
Short Put Spread
Risk Reversal
Aside: The Risk Reversal as a Skew Trade
Ratio Spreads
Conclusion
Summary
CHAPTER 9: Trade Sizing The Kelly Criterion
Non-normal Discrete Outcomes
Non-normal Continuous Outcomes
Uncertain Parameters
Kelly and Drawdown Control
The Effect of Stops
Conclusion
Summary
CHAPTER 10: Meta Risks Currency Risk
Theft and Fraud
Example One: Baring's Bank
Example Two: Yasumo Hamanaka, aka “Mr. Copper”
Example Three: Bernie Madoff
Index Restructuring
Arbitrage Counterparty Risk
Conclusion
Summary
CONCLUSION
APPENDIX 1: Traders' Adjustments to the BSM Assumptions The Existence of a Single, Constant Interest Rate
The Stock Pays No Dividends
Absence of Taxes
The Ability to Trade and Short the Underlying
Nonconstant Volatility
Conclusion
Summary
APPENDIX 2: Statistical Rules of Thumb Converting Range Estimates to Option Pricing Inputs
Rule of Five
Rule of Three
APPENDIX 3: Execution Example
REFERENCES
INDEX
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