Positional Option Trading: An Advanced Guide

A detailed, one-stop guide for experienced options traders Positional Option Trading: An Advanced Guide is a rigorous, professional-level guide on sophisticated techniques from professional trader and quantitative analyst Euan Sinclair. The author has over two decades of high-level option trading experience. He has written this book specifically for professional options traders who have outgrown more basic trading techniques and are searching for in-depth information suitable for advanced trading. Custom-tailored to respond to the volatile option trading environment, this expert guide stresses the importance of finding a valid edge in situations where risk is usually overwhelmed by uncertainty and unknowability. Using examples of edges such as the volatility premium, term-structure premia and earnings effects, the author shows how to find valid trading ideas and details the decision process for choosing an option structure that best exploits the advantage. Advanced topics include a quantitative approach for directionally trading options, the robustness of the Black Scholes Merton model, trade sizing for option portfolios, robust risk management and more. This book: Provides advanced trading techniques for experienced professional traders Addresses the need for in-depth, quantitative information that more general, intro-level options trading books do not provide Helps readers to master their craft and improve their performance Includes advanced risk management methods in option trading No matter the market conditions, Positional Option Trading: An Advanced Guide is an important resource for any professional or advanced options trader.

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