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Volatility Trading, + Website, 2nd Edition


Praise from experts for the Second Edition of Volatility Trading

"Benefitting from his experience as an option trader and his background as a physicist, Euan Sinclair gives a comprehensive and detailed treatment of theoretical and practical aspects involved in volatility trading. The style is to-the-point, focused, and honest. The book includes something rarer than a CD-ROM: humor. Heartily recommended for the practitioner, as well as the academic who wants to know."
—JESPER ANDREASEN, Danske Markets, Copenhagen

"Over the last five years, this has become the classic work on practical options trading. It has been updated to cover innovations in markets as well as additional material on behavioral finance and capturing risk premium Everyone who trades options should read this book."
—AARON BROWN, Risk Manager, AQR Capital Management, and author of Red-Blooded Risk

"Practical, engaging, and concise, Euan Sinclair's Volatility Trading remains the best book I have seen about options trading from the practitioner's standpoint. A far cry from the standard textbook treatment, Sinclair's discussion of practical topics such as trade sizing, exit criteria, and P&L management—peppered with relevant trading anecdotes—educates while countering many of the trader myths and fallacies one hears over the years. New material on trading the VIX and volatility ETFs is particularly timely and useful."
—STEVE CRUTCHFIELD, Head of U.S. Options, NYSE Euronext

EUAN SINCLAIR is an option trader with fifteen years' experience. 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 PhD in theoretical physics from the University of Bristol.

Acknowledgments xi

Introduction to the Second Edition xiii

CHAPTER 1 Option Pricing 1

The Black-Scholes-Merton Model 1

Modeling Assumptions 7

Conclusion 11

Summary 11

CHAPTER 2 Volatility Measurement 13

Defining and Measuring Volatility 13

Definition of Volatility 14

Alternative Volatility Estimators 20

Using Higher-Frequency Data 29

Summary 33

CHAPTER 3 Stylized Facts about Returns and Volatility 35

Definition of a Stylized Fact 35

Volatility Is Not Constant 36

Characteristics of the Return Distribution 40

Volume and Volatility 43

Distribution of Volatility 45

Summary 46

CHAPTER 4 Volatility Forecasting 49

Absence of Transaction Costs 50

Perfect Information Flow 50

Agreement about the Price Implications of Information 50

Maximum Likelihood Estimation 54

Volatility Forecasting Using

Fundamental Information 60

The Variance Premium 62

Summary 65

CHAPTER 5 Implied Volatility Dynamics 67

Volatility Level Dynamics 70

The Smile and the Underlying 80

Smile Dynamics 82

Term Structure Dynamics 90

Summary 91

CHAPTER 6 Hedging 93

Ad Hoc Hedging Methods 95

Utility-Based Methods 96

Estimation of Transaction Costs 109

Aggregation of Options on Different Underlyings 113

Summary 115

CHAPTER 7 Distribution of Hedged Option Positions 117

Discrete Hedging and Path Dependency 117

Volatility Dependency 123

Summary 129

CHAPTER 8 Money Management 131

Ad Hoc Sizing Schemes 131

The Kelly Criterion 133

Time for Kelly to Dominate 143

Effect of Parameter Mis-Estimation 144

What is Bankroll? 146

Alternatives to Kelly 148

Summary 161

CHAPTER 9 Trade Evaluation 163

General Planning Procedures 164

Risk-Adjusted Performance Measures 171

Setting Goals 178

Persistence of Performance 180

Relative Persistence 180

Summary 184

CHAPTER 10 Psychology 187

Self-Attribution Bias 191

Overconfidence 193

The Availability Heuristic 197

Short-Term Thinking 199

Loss Aversion 199

Conservatism and Representativeness 201

Confirmation Bias 203

Hindsight Bias 206

Anchoring and Adjustment 207

The Narrative Fallacy 208

Prospect Theory 209

Summary 212

CHAPTER 11 Generating Returns through Volatility 213

The Variance Premium 214

Reasons for the Variance Premium 220

Summary 222

CHAPTER 12 The VIX 223

The VIX Index 224

VIX Futures 225

Volatility ETNs 227

Other VIX Trades 229

Summary 230

CHAPTER 13 Leveraged ETFs 231

Leveraged ETFs as a Trade-Sizing Problem 234

A Long-Short Trading Strategy 234

Options on Leveraged ETFs 235

Summary 237

CHAPTER 14 Life Cycle of a Trade 239

Pretrade Analysis 239

Posttrade Analysis 245

Summary 247

CHAPTER 15 Conclusion 249

Summary 252

Resources 253

Directly Applicable Books 253

Thought-Provoking Books 256

Useful Websites 257

References 261

About the Website 273

About the Author 279

Index 281