EBOOK - Option Trading - Pricing and Volatility Strategies and Techniques (Euan Sinclair)

Traders tend to be a pragmatic group. They are largely interested in results. Actually some become so focused on results that it becomes a hindrance. This tendency can be a handicap, as the way to achieve good results is to focus on good processes and let the results take care of themselves. Good traders learn this.
But good traders are still intellectually parsimonious. They want to know what works, but seldom more than the minimum they need. When I’m feeling uncharitable I regard this as characteristic of the uncurious, dull people I have had the misfortune to work with, and indeed some were like this. More realistically, however, this is less a reflection on the traders themselves, most of who were intelligent people with a wide range of interests, and more a reflection on the nature of trading.
Trading is complex, changeable, and potentially emotionally draining. Once a trader has learned a sensible, statistically valid, profitable method, he is better off concentrating on exploiting it rather than continuing to experiment.
So a perfectly valid question when told something is “Why do I need to know this?” As a general answer, in the case where everything else is equal, the trader with more knowledge will make more money. He will also be more easily able to adapt to new markets and opportunities.
It is possible to trade options successfully without knowing about the Black-Scholes-Merton model, or any other pricing model. But for the traders who do this, everything is a special situation. They have to individually learn every nuance with no organizing principle. It would be like trying to learn chemistry without knowing about the periodic table. BlackScholes-Merton provides a simplifying framework. Traders who know this
can then learn other things more easily, because they use less energy remembering the otherwise unconnected facts.


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
viii CONTENTS
The Binomial Model 48
The Black-Scholes-Merton (BSM) Model 55
Summary 61
CHAPTER 5 The Solution of the
Black-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
Contents ix
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

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Traders tend to be a pragmatic group. They are largely interested in results. Actually some become so focused on results that it becomes a hindrance. This tendency can be a handicap, as the way to achieve good results is to focus on good processes and let the results take care of themselves. Good traders learn this.
But good traders are still intellectually parsimonious. They want to know what works, but seldom more than the minimum they need. When I’m feeling uncharitable I regard this as characteristic of the uncurious, dull people I have had the misfortune to work with, and indeed some were like this. More realistically, however, this is less a reflection on the traders themselves, most of who were intelligent people with a wide range of interests, and more a reflection on the nature of trading.
Trading is complex, changeable, and potentially emotionally draining. Once a trader has learned a sensible, statistically valid, profitable method, he is better off concentrating on exploiting it rather than continuing to experiment.
So a perfectly valid question when told something is “Why do I need to know this?” As a general answer, in the case where everything else is equal, the trader with more knowledge will make more money. He will also be more easily able to adapt to new markets and opportunities.
It is possible to trade options successfully without knowing about the Black-Scholes-Merton model, or any other pricing model. But for the traders who do this, everything is a special situation. They have to individually learn every nuance with no organizing principle. It would be like trying to learn chemistry without knowing about the periodic table. BlackScholes-Merton provides a simplifying framework. Traders who know this
can then learn other things more easily, because they use less energy remembering the otherwise unconnected facts.


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
viii CONTENTS
The Binomial Model 48
The Black-Scholes-Merton (BSM) Model 55
Summary 61
CHAPTER 5 The Solution of the
Black-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
Contents ix
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

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