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    Volatility Trading
    Volatility Trading
    Volatility Trading
    Ebook365 pages4 hours

    Volatility Trading

    By Euan Sinclair

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    About this ebook

    In Volatility Trading, Sinclair offers you a quantitative model for measuring volatility in order to gain an edge in your 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. In addition, Sinclair explains the often-overlooked psychological aspects of trading, revealing both how behavioral psychology can create market conditions traders can take advantage of-and how it can lead them astray. Psychological biases, he asserts, are probably the drivers behind most sources of edge available to a volatility trader.

    Your goal, Sinclair explains, must be clearly defined and easily expressed-if you cannot explain it in one sentence, you probably aren't completely clear about what it is. The same applies to your statistical edge. If you do not know exactly what your edge is, you shouldn't trade. He shows how, in addition to the numerical evaluation of a potential trade, you should be able to identify and evaluate the reason why implied volatility is priced where it is, that is, why an edge exists. This means it is also necessary to be on top of recent news stories, sector trends, and behavioral psychology. Finally, Sinclair underscores why trades need to be sized correctly, which means that each trade is evaluated according to its projected return and risk in the overall context of your goals.

    As the author concludes, while we also need to pay attention to seemingly mundane things like having good execution software, a comfortable office, and getting enough sleep, it is knowledge that is the ultimate source of edge. So, all else being equal, the trader with the greater knowledge will be the more successful. This book, and its companion CD-ROM, will provide that knowledge. The CD-ROM includes spreadsheets designed to help you forecast volatility and evaluate trades together with simulation engines.
    LanguageEnglish
    PublisherWiley
    Release dateJan 11, 2011
    ISBN9781118045299
    Volatility Trading

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      Book preview

      Volatility Trading - Euan Sinclair

      Introduction

      This book is about trading volatility. More specifically it is about using options to make trades that are primarily dependent on the range of the underlying instrument rather than its direction.

      Before discussing technicalities, I want to give a brief description of my trading philosophy. In trading, as in most things, it is necessary to have general guiding principles in order to succeed. Not everyone need agree on the specific philosophy, but its existence is essential. For example, it is possible to be a successful stock market investor by focusing on valuestyle investing, buying stocks with low price-to-earnings or price-to-book ratios. It is also possible to be a successful growth investor, buying stocks in companies that have rapidly expanding earnings. It is not possible to succeed consistently by randomly acquiring stocks and hoping that things just work out.

      I am a trader. I am not a mathematician, financial engineer, or philosopher. My success is measured in profits. The tools I use and develop need only be useful. They need not be consistent, provable, profound, or even true. My approach to trading is mathematical, but I am no more interested in mathematics than a mechanic is interested in his tools. However, a certain level of knowledge, familiarity, and even respect is needed to get the most out of these tools.

      There will be no attempt here to give a list of trading rules. Sorry, but markets constantly evolve and rules rapidly become obsolete. What will not become obsolete are general principles. These are what I will attempt to provide. This approach isn’t as easy to digest as a list of magic rules, but I do not claim markets are easy to beat, either. The specifics of any trade will always be different, but general guidelines can always point us somewhat in the right direction. Some latitude in strategy is desirable and adaptability is essential, but there are also a number of things that have to be firmly in place in order to succeed. Picasso and Braque may have broken a lot of rules, but they could certainly paint technically very well before they did so. Before you start adjusting, make sure you have a good grasp of the fundamental aspects on which all trades need to be based: edge, variance, and appropriate size.

      Certain old-school traders have used arguments like Trading is about humans. Your models can’t capture the human element. This generally seems to be said in a defensive manner. Maybe their models can’t capture the human element, but ours will capture at least part of it. Most of the reluctance of such traders to embrace quantitative techniques can be attributed to defensiveness and aversion to change. It probably isn’t due to any deep aversion to quantification. After all, in the same way that traditional baseball people hate the new statistical analyses but are fine with batting average and earned run averages, many traditional option traders denigrate quantitative analysis while being perfectly happy with the Black-Scholes-Merton paradigm and the concept of implied volatility. They are probably just unwilling to admit that they need to continue to learn and are worried that their skills are becoming obsolete. They should be. We all should be. This is a continually evolving process.

      However, when successful traders say something like this, we need to consider that they may be partly correct. Some traders do indeed have finely honed intuition, generally called feel when applied to market sense. Intuition exists and can even be developed, but generally not quickly. Also, just because some traders have feel does not mean all, or even many, do. The approach we develop based on mathematics and measurement can be systematically learned. Given that it can be learned, what excuse is there not to learn it? Further, while a logic-based trader may never be able to develop effective intuition, an intuitive trader can always benefit from logic-based reasoning.

      While markets are designed and populated by human traders, with their typical human emotions and foibles, there is no justification for using this as a reason to avoid quantification and measurement. Baseball is also a game played by humans, and batting average is a useful way to measure the quality of a hitter. Similarly, before making a trade we need to be able to somehow quantify the level of risk we will be incurring and the amount of edge we expect to gather. This is exactly what mathematics is good for. Estimating return and risk (however we define it) is purely a mathematical task. If something cannot be measured it cannot be managed. Further, if the human element is going to be important to our success, it will need to have measurable effects. The markets may indeed be driven by animal spirits, but I will remain thoroughly agnostic until they turn into poltergeists and start to actually throw prices around.

      Pragmatism must always be our guiding philosophy. When I have had to choose between including something because I have found it useful, or omitting it because I could not prove it, I have tended to err on the side of inclusion. Successful trading is based on making correct decisions under conditions of uncertainty and incomplete information. There will always be things that we suspect are true but cannot prove. Waiting for proof may well mean waiting until the methods are no longer useful.

      There are almost certainly other ways to trade options successfully. What I offer is a way, not the way. It is very much a data-driven, statistically oriented approach that needs to be applied over a wide range of products. It is like hunting with a shotgun rather than a rifle (actually, it may well be more like carpet bombing from 30,000 feet). But even traders who focus on one or two markets should be able to find some things useful and directly applicable. Traders who do not trade options should nevertheless find aspects of the book useful as well.

      THE TRADING PROCESS

      Trading can be broken down into three main areas: finding profitable trades, managing risk and bankroll, and psychology. There is very little to be gained by arguing over their respective levels of importance. While most traders will be more proficient in one of the three aspects than the others, they must all be present for a trading operation to be a success.

      When trading options, finding an edge involves forecasting volatility and understanding how volatility determines the market price of options. This means we need a model for translating between price space and volatility space. Over the past 40 years, traders and financial engineers have proposed a number of option pricing models of varying complexity. We choose to use the Black-Scholes-Merton (BSM) methodology. Traders have learned to think in BSM terms. As a trader once said to me, I want a model that a lot of guys have blown up using. He meant that a good model was one whose weaknesses were well known and had been discovered by someone else’s misfortune, rather than one whose weaknesses have yet to be discovered. (Ironically, the same trader later blew up using the BSM paradigm. So it goes.)

      There is a misconception that more complex models are better. But it doesn’t matter how complex the model is. If a trader sells an option for 5.0 and buys it back for 3.0, he makes two ticks no matter what model he is using. A model is just a way to formulate our thoughts and translate between our volatility forecasts and the option prices. If someone is comfortable with a stochastic volatility model, he is more than welcome to use it. However, I have found the BSM framework is robust enough to have a number of modifications added to it to make it more representative of reality while still remaining simple and intuitive.

      While most stock and commodity options are American style and hence not technically priced using this equation,¹ knowledge of the derivation of the pricing equation is necessary to get any feel for options. In our derivation we will emphasize the elements that we hope to profit from. The market thinks in Black-Scholes terms, and to trade against it we need to understand what it really means. Trading is like a debate: In order to sensibly disagree with someone, we need to at least understand what they are saying.

      Our derivation of this model in Chapter 1 is very informal. It directly proceeds from the starting point of holding a directionally neutral portfolio and shows how adjusting this dynamically leads to the BSM equation. It also makes clear the direct dependence of the equation on the range of the underlying and how this is proxied by volatility of returns. We also emphasize all the approximations and assumptions that are needed to arrive at the BSM equation. The rest of this book shows in detail how to deal with and profitably trade these inadequacies.

      The largest source of edge in option trading is in trading our estimate of future volatility against the markets. Before we can forecast volatility we need to be able to measure it. In Chapter 2 we look at methods of historical volatility measurement including close-to-close volatility, Parkinson volatility, Rogers-Satchell volatility, Garman-Klass volatility, and Yang-Zhang volatility. We discuss the efficiency and bias of each estimator and also how each is perturbed by different aspects of real markets, such as fat tails in the return distribution, trends, and microstructure noise. We discuss different frequencies of measurement.

      Next we try to forecast the volatility that will be present over the lifetime of the trade. We look at simple moving window forecasts, exponentially weighted moving averages, and various members of the GARCH family. But for trading we need more than a point estimate of future volatility. We need some estimate of the possible range of volatilities so we can make sensible judgments about the risk/reward characteristics of prospective trades. To find this we examine the construction and sampling properties of volatility cones.

      Although our focus is to look for situations where implied volatility is at variance with our forecast of realized volatility, dynamics of the implied volatility surface are also interesting and important. An understanding can help our trade execution and timing. In Chapter 3 we look at normal shapes of the volatility surface both over time and by strike. We examine implied skewness and its sources, including credit, actual skewness of returns, put buying as static hedges, call buying as takeover hedging, and index skewness from implied correlation. We extend the Black-Scholes paradigm to include skewness and kurtosis and provide several rules of thumb for comparing volatilities across time and underlying product.

      In order to profit from our forecast of volatility we need to hedge, so that our risk is actually realized volatility. Hedging removes the risks that we do not wish to take. We wish to accept risks that we believe to be mispriced and eliminate or at least mitigate our exposure to other sources of risk. With the simple, exchange-traded options that we generally consider, these unwanted risks are the drift of the underlying and movement in interest rates. Hedging is costly but it reduces risk. So when exactly should we hedge? In Chapter 4 we examine how to optimally solve this risk/reward issue. We also look at how to aggregate our positions to further reduce the need for hedging.

      Once our position is hedged, what can we expect to happen? Chapter 5 examines the profit-and-loss distribution of a discretely hedged position and shows how this changes depending on the volatility we choose to use for delta estimation and the particular path taken by the underlying.

      This completes the first stage in the trade process: finding a trade with a positive expectation. Now we need to look at how portfolio management choices can affect our success.

      Chapter 6 demonstrates how different choices for trade sizing can dramatically affect returns. We introduce Kelly betting and compare it with other schemes, such as fixed-sized trading and proportional sizing. We also note how the sizing decisions affect risk by looking at risk of ruin and drawdowns. This is initially done for the simplest possible case, a trade that has a binary outcome. This is a long way from being even a partially realistic model of reality, but it is necessary to start with such simple examples, as even traders with many years of experience seem to have very little if any idea of the implications of trade sizing. They obviously are aware that it is better to play a game with a positive edge many times so as to take advantage of the law of large numbers, but rarely take their understanding beyond this level. Futures traders seem to know more about this than options traders. Gamblers know even more. Most of the research in this area has been done by gamblers, particularly blackjack players. (Generally, it seems that the more complex the financial product, the less complex is the actual trading process, ranging from the very complex blackjack strategy and sizing decisions to the trading of structured derivatives, where most of the edge lies in pricing and sales.)

      Volatility trading is not binary in outcome. We need to extend Kelly to deal with situations that have a continuum of outcomes. (We really just need to extend the generally used version of the Kelly criterion. The Kelly criterion itself is far more general than the version that is often presented). Further, volatility is a mean-reverting processes. We must again extend our sizing methodology to account for this and show by simulations how this leads to familiar (to market makers) and simple scaling rules.

      We also present some alternatives to the Kelly paradigm that may be more applicable to trading situations where the long run is of less interest than the short term. Traders should be aware of these methods. People who allocate capital to traders should be even more aware of them. Generally traders and trading firms will have somewhat different sets of priorities here.

      In order to distinguish our results from chance we need to keep careful track of the results of our trades. In particular we need to be aware of much more than total profit and loss. This is particularly important in evaluating the efficacy of a new trade. Chapter 7 examines a number of measures including win/loss ratios; drawdowns; Sharpe, Calmar, and Sortino ratios; and the omega measure. Unfortunately, this type of record keeping and post-trade analysis is often left undone. I believe that this is the most important aspect of trading, and also the most often overlooked. How can you improve if you don’t really know what your results are?

      Psychology is often mentioned in trading books. But successful trading is emphatically not due to being confident, reading the market or having no fear (although I was recently told that this was why a particular trader was good). This book does not go into this self-help style of psychology. Most of the psychological topics dealt with in books for amateurs or semiprofessionals can be addressed by sound money management rules and a sensible means of finding and measuring edge. However, knowledge of behavioral finance can be useful to even experienced traders. In Chapter 8 we look through some of the cognitive and emotional biases option traders will most often experience, both from a defensive and offensive viewpoint: things to watch out for to avoid hurting our own trading, and things to look for in the market that can be profitably exploited. Most sources of edge exist because of some behavioral aspect of psychology.

      Finally, we examine one trade in detail, going through its complete life cycle from conception to expiration.

      CHAPTER 1

      Option Pricing

      In order to profitably trade options we need a model for valuing them. This is a framework we can use to compare options of different maturities, underlyings, and strikes. We do not insist that it is in any sense true or even a particularly accurate reflection of the real world. As options are highly leveraged, nonlinear, time-dependent bets on the underlying, their prices change very quickly. The major goal of a pricing model is to translate these prices into a more slowly moving system.

      A model that perfectly captures all aspects of a financial market is probably unobtainable. Further, even if it existed it would be too complex to calibrate and use. So we need to somewhat simplify the world in order to model it. Still, with any model we must be aware of the simplifying assumptions that are being used and the range of applicability. The specific choice of model isn’t as important as developing this level of understanding.

      THE BLACK-SCHOLES-MERTON MODEL

      We present here an analysis of the Black-Scholes-Merton (BSM) equation. The BSM formalism becomes the conceptual framework for an options trader: In the same way that we hear our own thoughts in English, an experienced derivatives trader thinks in the BSM language.

      The standard derivation of the BSM equation can be found in any number of places (for example, Hull 2005). While good derivations carefully lead us through the mathematics and financial assumptions, they don’t generally make it obvious what to do as a trader. We must always remember that our goal is to identify and profit from mispriced options. How does the BSM formalism help us do this?

      Here we approach the problem backwards. We start from the assumption that a trader holds a delta hedged portfolio consisting of a call option and Δ units of short stock.² We then apply our knowledge of option dynamics to derive the BSM equation.

      Even before we make any assumptions about the distribution of underlying returns, we can state a number of the properties that an option must possess. These should be financially obvious.

      • A call (put) becomes more valuable as the underlying rises (falls), as it has more chance of becoming intrinsically valuable.

      • An option loses value as time passes, as it has less time to become intrinsically valuable.

      • An option loses value as rates increase. Since we have to borrow money to pay for options, as rates increase our financing costs increase, ignoring for now any rate effects on the underlying.

      • The value of a call (put) can never be more than the value of the underlying (strike).

      As we have said, even before the invention of the BSM formalism, option traders were aware that directional risk could be mitigated by combining their options with a position in the underlying. So let’s assume we hold the delta hedged option position,

      (1.1)

      002

      where

      C is the value of the option

      St is the underlying price at time t

      Δ is the number of shares we are short

      Over the next time step the

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