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Volatility Trading, + Website, 2nd Edition

ISBN: 978-1-118-34713-3
320 pages
April 2013
Volatility Trading, + Website, 2nd Edition (1118347137) cover image


Popular guide to options pricing and position sizing for quant traders

In this second edition of this bestselling book, Sinclair offers a quantitative model for measuring volatility in order to gain an edge in 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. This new edition includes new chapters on the dynamics of realized and implied volatilities, trading the variance premium and using options to trade special situations in equity markets.

  • Filled with volatility models including brand new option trades for quant traders
  • Options trader Euan Sinclair specializes in the design and implementation of quantitative trading strategies

Volatility Trading, Second Edition + Website outlines strategies for defining a true edge in the market using options to trade volatility profitably.

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Table of Contents

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

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Author Information

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.

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Press Release

April 22, 2013
Volatility Trading, + Website, 2nd Edition

Volatility, by definition, is indicative of underlying randomness. But there are patterns within the noise that can be measured and exploited. No one knows this better than author Euan Sinclair, a highly successful options trader with a doctorate in quantum chaos.

But the Second Edition of Volality Trading isn't just about the numbers. Drawing upon his fifteen years as a professional trader, Sinclair provides a fully fleshed-out approach to trading that relies as much on the all-important "human element" and the psychological and emotional biases that drive trading decisions, as it does on quantitative analysis.

Ultimately, says Sinclair, trading is about having a coherent trading philosophy and developing a rigorous system. It's about setting a goal that can be clearly expressed in one sentence, and about finding trades with a clear statistical edge. And, finally, it's about capturing that edge and sizing each trade in a way that is consistent with your goal. Everything you do as a trader must be done within this framework.

Taking an accessible, straightforward approach, Sinclair provides you with the knowledge and tools you need to create just such a framework. He walks you through the basics of option pricing, volatility measurement, hedging, money management, and performance evaluation. And he develops a Black-Scholes-Merton-based quantitative model for measuring volatility that can easily can be adapted to trading virtually any type of financial instrument.

Responding to major changes in the markets since the first edition, Sinclair has expanded his scope in thisSecond Edition to include coverage of the many new opportunities available in VIX futures, ETNs, and leveraged ETFs. He also:

  • Analyzes the benefits and shortcomings of an array of historical volatility measurements
  • Clearly shows how volatility behaves in the real world and how it relates to returns on underlying assets
  • Outlines methods for forecasting volatility over the lifetime of a trade
  • Supplies proven techniques for knowing when to hedge and by how much
  • Delivers strategies for aggregating positions so as to reduce the need to hedge
  • Shares priceless tips on how to boost returns through trade sizing—including techniques borrowed from the worlds of futures trading and professional gambling
  • Arms you with powerful tools for evaluating the ongoing performance of your trading activity
  • Fills you in on the latest research on cognitive and emotional biases that influence trading decisions and how to leverage them to your advantage
  • Delineates time-tested strategies for trading VIX futures, ETNs, and leveraged ETFs
  • Provides access to a companion website containing valuable spreadsheets, models for calculating volatility cones for different time periods, and simulation engines

Bringing volatility trading down to earth for even the most numbers-shy traders, as well as hard-nosed quants interested in acquiring a deeper understanding of options trading, Volatility Trading, Second Edition is an indispensable "tool of the trade."

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