Positional Option Trading

Euan Sinclair, PhD, is an options trader and financial engineer at Hull Tactical. He holds a doctorate in theoretical physics from the University of Bristol.

• Introduction xiTrading as a Process xiiiSummary xvChapter 1 Options: A Summary 1Option Pricing Models 1Option Trading Theory 4Conclusion 10Summary 10Chapter 2 The Efficient Market Hypothesis and Its Limitations 11The Efficient Market Hypothesis 11Aside: Alpha Decay 15Behavioral Finance 16High-Level Approaches: Technical Analysis and Fundamental Analysis 21Conclusion 27Summary 27Chapter 3 Forecasting Volatility 29Model-Driven Forecasting and Situational Forecasting 30The GARCH Family and Trading 33Implied Volatility as a Predictor 36Ensemble Predictions 36Conclusion 38Summary 38Chapter 4 The Variance Premium 39Aside: The Implied Variance Premium 40Variance Premium in Equity Indices 42The Implied Skewness Premium 46The Implied Correlation Premium 47Commodities 47Bonds 49The VIX 50Currencies 50Equities 50Reasons for the Variance Premium 51Insurance 52Jump Risk 52Trading Restrictions 52Market-Maker Inventory Risk 52Path Dependency of Returns 53The Problem of the Peso Problem 55Conclusion 56Summary 56Chapter 5 Finding Trades with Positive Expected Value 57Aside: Crowding 57Trading Strategies 61Options and Fundamental Factors 63Post-Earnings Announcement Drift (PEAD) 68Confidence Level Two 71The Overnight Effect 75FOMC and Volatility 75The Weekend Effect 77Volatility of Volatility Risk Premia 78Confidence Level One 80Earnings-Induced Reversals 80Pre-Earnings Announcement Drift 81Conclusion 82Summary 83Chapter 6 Volatility Positions 85Aside: Adjustment and Position ‘‘Repair’’ 86Straddles and Strangles 86Aside: Delta-Hedged Positions 93Butterflies and Condors 95Aside: Broken Wing Butterflies and Condors 99Calendar Spread 100Including Implied Volatility Skew 102Strike Choice 104Choosing a Hedging Strike 107Expiration Choice 109Conclusion 111Summary 111Chapter 7 Directional Option Trading 113Subjective Option Pricing 113A Theory of Subjective Option Pricing 115Distribution of Option Returns: Summary Statistics 118Strike Choice 120Fundamental Considerations 124Conclusion 124Summary 125Chapter 8 Directional Option Strategy Selection 127Long Stock 128Long Call 129Long Call Spread 130Short Put 131Covered Calls 131Components of Covered Call Profits 134Covered Calls and Fundamentals 136Short Put Spread 137Risk Reversal 138Aside: The Risk Reversal as a Skew Trade 141Ratio Spreads 142Conclusion 145Summary 145Chapter 9 Trade Sizing 147The Kelly Criterion 147Non-normal Discrete Outcomes 149Non-normal Continuous Outcomes 151Uncertain Parameters 154Kelly and Drawdown Control 158The Effect of Stops 161Conclusion 170Summary 170Chapter 10 Meta Risks 171Currency Risk 171Theft and Fraud 173Example One: Baring’s Bank 174Example Two: Yasumo Hamanaka, aka ‘‘Mr. Copper’’ 175Example Three: Bernie Madoff 176Index Restructuring 177Arbitrage Counterparty Risk 178Conclusion 179Summary 179Conclusion 181Appendix 1 Traders’ Adjustments to the BSM Assumptions 183The Existence of a Single, Constant Interest Rate 183The Stock Pays No Dividends 186Absence of Taxes 186The Ability to Trade and Short the Underlying 187Nonconstant Volatility 190Conclusion 192Summary 193Appendix 2 Statistical Rules of Thumb 195Converting Range Estimates to Option Pricing Inputs 195Rule of Five 196Rule of Three 197Appendix 3 Execution 199Example 204References 207Index 219