Volatility Trading

Popular guide to options pricing and position sizing for quant traders

In this second edition of this bestselling book, Sinclair offers a quantitative model for measuring volatility in order to gain an edge in everyday option trading endeavors. With an accessible, straightforward approach, he guides traders through the basics of option pricing, volatility measurement, hedging, money management, and trade evaluation. This new edition includes new chapters on the dynamics of realized and implied volatilities, trading the variance premium and using options to trade special situations in equity markets.
* Filled with volatility models including brand new option trades for quant traders
* Options trader Euan Sinclair specializes in the design and implementation of quantitative trading strategies

Volatility Trading, Second Edition + Website outlines strategies for defining a true edge in the market using options to trade volatility profitably.

Acknowledgments xi
Introduction to the Second Edition xiii
Chapter 1 Option Pricing 1
The Black-Scholes-Merton Model 1
Modeling Assumptions 7
Conclusion 11
Summary 11
Chapter 2 Volatility Measurement 13
Defining and Measuring Volatility 13
Definition of Volatility 14
Alternative Volatility Estimators 20
Using Higher-Frequency Data 29
Summary 33
Chapter 3 Stylized Facts about Returns and Volatility 35
Definition of a Stylized Fact 35
Volatility Is Not Constant 36
Characteristics of the Return Distribution 40
Volume and Volatility 43
Distribution of Volatility 45
Summary 46
Chapter 4 Volatility Forecasting 49
Absence of Transaction Costs 50
Perfect Information Flow 50
Agreement about the Price Implications of Information 50
Maximum Likelihood Estimation 54
Volatility Forecasting Using Fundamental Information 60
The Variance Premium 62
Summary 65
Chapter 5 Implied Volatility Dynamics 67
Volatility Level Dynamics 70
The Smile and the Underlying 80
Smile Dynamics 82
Term Structure Dynamics 90
Summary 91
Chapter 6 Hedging 93
Ad Hoc Hedging Methods 95
Utility-Based Methods 96
Estimation of Transaction Costs 109
Aggregation of Options on Different Underlyings 113
Summary 115
Chapter 7 Distribution of Hedged Option Positions 117
Discrete Hedging and Path Dependency 117
Volatility Dependency 123
Summary 129
Chapter 8 Money Management 131
Ad Hoc Sizing Schemes 131
The Kelly Criterion 133
Time for Kelly to Dominate 143
Effect of Parameter Mis-Estimation 144
What is Bankroll? 146
Alternatives to Kelly 148
Summary 161
Chapter 9 Trade Evaluation 163
General Planning Procedures 164
Risk-Adjusted Performance Measures 171
Setting Goals 178
Persistence of Performance 180
Relative Persistence 180
Summary 184
Chapter 10 Psychology 187
Self-Attribution Bias 191
Overconfidence 193
The Availability Heuristic 197
Short-Term Thinking 199
Loss Aversion 199
Conservatism and Representativeness 201
Confirmation Bias 203
Hindsight Bias 206
Anchoring and Adjustment 207
The Narrative Fallacy 208
Prospect Theory 209
Summary 212
Chapter 11 Generating Returns through Volatility 213
The Variance Premium 214
Reasons for the Variance Premium 220
Summary 222
Chapter 12 The VIX 223
The VIX Index 224
VIX Futures 225
Volatility ETNs 227
Other VIX Trades 229
Summary 230
Chapter 13 Leveraged ETFs 231
Leveraged ETFs as a Trade-Sizing Problem 234
A Long-Short Trading Strategy 234
Options on Leveraged ETFs 235
Summary 237
Chapter 14 Life Cycle of a Trade 239
Pretrade Analysis 239
Posttrade Analysis 245
Summary 247
Chapter 15 Conclusion 249
Summary 252
Resources 253
Directly Applicable Books 253
Thought-Provoking Books 256
Useful Websites 257
References 261
About the Website 273
About the Author 279
Index 281