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.
Table of Content
Introduction 1
The Trading Process 3
Chapter 1 Option Pricing 7
The Black-Scholes-Merton Model 7
Summary 14
Chapter 2 Volatility Measurement and Forecasting 15
Defining and Measuring Volatility 15
Definition of Volatility 16
Alternative Volatility Estimators 22
Close-to-Close Estimator 26
Parkinson Estimator 26
Garman-Klass Estimator 27
Rogers-Satchell Estimator 27
Yang-Zhang Estimator 27
Using Higher-Frequency Data 27
Forecasting Volatility 31
Maximum Likelihood Estimation 36
Forecasting the Volatility Distribution 39
Summary 43
Chapter 3 Implied Volatility Dynamics 45
Volatility Level Dynamics 48
Informal Definition 50
More Formal Definition 50
A Traders’ Definition 50
Smile Dynamics 54
Summary 62
Chapter 4 Hedging 63
Ad Hoc Hedging Methods 65
Hedging at Regular Intervals 65
Hedging to a Delta Band 65
Hedging Based on Underlying Price Changes 65
Utility-Based Methods 66
The Asymptotic Solution of Whalley and Wilmott 71
The Double Asymptotic Method of Zakamouline 74
Estimation of Transaction Costs 78
Aggregation of Options on Different Underlyings 83
Summary 85
Chapter 5 Hedged Option Positions 87
Discrete Hedging and Path Dependency 87
Volatility Dependency 93
Summary 99
Chapter 6 Money Management 101
Ad Hoc Schemes 101
The Kelly Criterion 103
Alternatives to the Kelly Criterion 113
Trade Sizing in a Continuously Changing Setting 118
A Simple Approximation 124
Summary 126
Chapter 7 Trade Evaluation 127
General Planning Procedures 128
Risk-Adjusted Performance Measures 134
The Sharpe Ratio 135
Alternatives to the Sharpe Ratio 137
Setting Goals 140
Persistence of Performance 142
Relative Persistence 143
Absolute Persistence 144
Summary 147
Chapter 8 Psychology 149
Self-Attribution Bias 151
Overconfidence 152
The Availability Heuristic 155
Short-Term Thinking 156
Loss Aversion 157
Conservatism and Representativeness 158
Confirmation Bias 160
Hindsight Bias 161
Anchoring and Adjustment 162
Summary 162
Chapter 9 Life Cycle of a Trade 165
Pretrade Analysis 165
June 25, 2007 165
June 26, 2007 169
June 27, 2007 169
June 28, 2007 170
June 29, 2007 170
July 2, 2007 170
July 3, 2007 170
Post-Trade Analysis 171
Summary 173
Chapter 10 Conclusion 175
Execution Ability 176
Concentration 177
Product Selection 177
Appendix A: Model-Free Implied Variance and Volatility 179
The VIX Index 180
Appendix B: Spreadsheet Instructions 183
GARCH 183
Volatility Cones and Skew and Kurtosis Cones 184
Daily Option Hedging Simulation 184
Trade Evaluation 185
Trading Goals 185
Corrado-Su Skew Curve 185
Mean Reversion Simulator 186
Resources 187
Essential Books 187
Thought-Provoking Books 189
Useful Web Sites 190
References 193
About the CD-ROM 201
Index 203
About the author
EUAN SINCLAIR is an option trader with over ten years of experience trading options professionally. He specializes in the design and implementation of quantitative trading strategies. Sinclair is currently a proprietary option trader for Bluefin Trading, where he trades based on quantitative models of his own design. He holds a Ph D in theoretical physics from the University of Bristol.
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