Preface xiii

Acknowledgments xv

Introduction xvii

**PART I: UNDERSTANDING THE RELATIONSHIP BETWEEN MARKET TURBULENCE AND OPTION VOLATILITY 1**

**CHAPTER 1 Managing Risk and Uncertainty with Options 3**

What Is Risk? 4

What Is Uncertainty? 4

Seven Lessons Learned from Market Volatility 5

Understanding Derivatives 7

The Six Benefits of Options 9

**CHAPTER 2 Making Sense of Volatility in Options Trading 13**

Volatility as an Asset Class 14

Analyzing Volatility with Implied Volatility 16

What Does Implied Volatility Reveal? 16

Making Trading Decisions Based on the Disparity between

Historical and Implied Volatility 17

Appreciating Volatility for All It Is Worth 19

How Volatility Really Works on the Trading Floor 20

Volatility and Uncertainty: Lessons for the Irrational Option Trader 21

Varieties of Option Volatility Trading 23

**CHAPTER 3 Working with Volatility to Make Investment Decisions 25**

On Predicting the Future 25

Starting with Historical Volatility 27

Implied Volatility 32

Why Do Volatilities Increase as Equities Fall? 35

Implied Versus Historical Volatility 36

Justification for the Disparity between Historical and Implied Volatility 37

**CHAPTER 4 Volatility Skew: Smile or Smirk? 39**

Considering Some Examples 40

A Primer on Random Walk and Normal Distribution 41

Dealing with the Higher Moments of the Normal Distribution 45

Skew Is High, Skew Is Low. So What? 47

Does a “Flat” or “Steep” Skew Predict the Future? 48

A Fair Warning about Thinking about Skew too Much 49

**CHAPTER 5 Fixated on Volatility and the VIX: What Is Volatility, Anyhow? 51**

What We (Think) We Know 52

Definitions of VIX 54

Grasping the VIX Index 54

VIX—A (Very) Brief History 55

VIX: Calculation and Interpretation with a Simple Calculator 56

Important Insights on the VIX Index 57

What Does the VIX Tell Us? 58

VIX and Perhaps the Biggest Misnomer of All! 59

**PART II: UNDERSTANDING OPTION VOLATILITY AND ITS RELATIONSHIP TO OPTION GREEKS, PERSONAL DECISION MAKING, AND ODDS CREATION 61**

**CHAPTER 6 Extreme Volatility and Option Delta 63**

The Misnomer of Delta and Probability of Exercise 63

Delta Defined 65

The Relationship Between Volatility and Delta 69

Higher Volatility and Delta 70

Lower Volatility and Delta 70

Delta, Time, and Volatility 71

Delta, Position Delta, Volatility, and the Professional Trader 72

**CHAPTER 7 Smoke and Mirrors: Managing Gamma through Volatile Markets 75**

Gamma and Volatility 78

Managing Positive Gamma during a High-Volatility Environment 79

The Bad News: There’s Always More than Meets the Eye 80

Practical Considerations for Managing Long Gamma in a High-Volatility Environment 81

Managing Negative Gamma in a High-Volatility Environment 82

Practical Considerations of Negative Gamma in High Volatility 84

Gamma and Volatility with Respect to Time Structure 85

Summary 86

**CHAPTER 8 Price Explosion: Volatility and Option Vega 87**

The Relationship between Implied Volatility and Vega 88

Implied Volatility: Price Analogy 90

Option Vega and Time 90

Option Vega and Its Greek Cousins 91

Option Vega Implications 91

Don’t Underestimate the Relationship between

Volatility and Option Vega 91

Volatility and Vega Insensitivity 93

Important Concepts When Applying Option Vega in a

Volatile Marketplace 94

Summary 97

**CHAPTER 9 Sand in the Hourglass: Volatility and Option Theta 99**

Balancing Time Decay with Volatility: Mistakes Traders Make 101

Volatility and Theta: What Every Investor Needs to Know 106

**CHAPTER 10 The Nuances of Volatility: Interpreting the Mix of Academics and the Study of Volatility 109**

The Complication Surrounding Vega Risk in an Option Position 110

Implied Volatility Skew1Term Structure5Volatility Surface 111

Implied Volatility Term Structure 114

Did You Know Your Volatility Has Volatility? 115

The Normal Value of Volatility 117

**PART III: TEN PROVEN STRATEGIES TO EMPLOY IN UNCERTAIN TIMES 119**

**CHAPTER 11 Preparing for Trading Using Volatility Strategies 121**

The Elements of a Sound Trading Decision 122

Developing an Approach to Options Trading 123

The Mind of a Successful Trader 126

Decision Making, Options versus Everything Else 128

**CHAPTER 12 The Buy-Write, or the Covered Call 131**

The Buy-Write (Covered Call) Defined 131

An Example of the Covered Call Strategy 132

The Theory and Reality of the Covered Call 133

Covered Call Writing and Implied Volatility 137

Implied Volatility in Practice 138

Managing Contracts in a Time of High Volatility or a Falling Market 142

Effective Call Writing in a Volatile Market 143

**CHAPTER 13 Covering the Naked Put 145**

Contemplating the Cash-Secured Put 147

Utilizing the Cash-Secured Put in a High-Volatility Environment 149

Cash-Secured Put and Volatility: Risks and Consequences 152

Income Strategy: Volatility as an Asset Class and Cash-Secured Puts 154

Position Management 155

**CHAPTER 14 The Married Put: Protecting Your Profit 157**

Volatility, Downside Risk, and the Case for Portfolio Insurance 157

Why Buy High Volatility? 158

The Married Put 159

How and When to Use a Married Put 161

Example of When to Use a Married Put 162

The Married Put: Limiting Loss, Neutralizing Volatility, and

Unleashing Upside Potential 165

Married Put: A Real-Life Illustration 166

**CHAPTER 15 The Collar: Sleep at Night 169**

Collar Strategy 169

Types of Collars 173

Summary 177

Conclusions on the Collar Strategy 181

**CHAPTER 16 The Straddle and Strangle: The Risks and Rewards of Volatility-Sensitive Strategies 187**

The Buying or Selling of Premium 188

Properties of Straddles and Strangles 188

Comparing Straddles and Strangles 189

How to Compare Historical and Implied Volatility 192

The Impact of Correlation and Implied Volatility Skew 193

An Alternative to the Naked Volatility Sale via the Straddle/Strangle:

The Strangle Swap 194

**CHAPTER 17 The Vertical Spread and Volatility 201**

Introduction to the Vertical Spread 202

A Trader’s Reasoning for Trading a Vertical Spread 203

Designing Your Vertical Spread 205

Vertical Spreads and Greek Exposure 208

Vertical Spreads as a Pure Volatility Play 211

Comparing Volatility’s Effect on Vertical Spreads 212

Summary: Comparing Vertical Spreads and Implied Volatility 213

**CHAPTER 18 Calendar Spreads: Trading Theta and Vega 217**

Calendar Spreading—Trading Time 218

Risks and Rewards of the Calendar Spread 219

A Calendar Spread with a Bullish Expectation 220

Considerations and Observations for Calendar Spreads and Volatility 222

**CHAPTER 19 Ratio Spreading: Trading Objectives Tailor Made 227**

How Back Spreads and Ratio Spreads Work 227

Back Spreads 229

Ratio Spreads 231

Greek Values and the Back Spread or Ratio Spread 232

Configuring and Pricing a Back Spread or Ratio Spread 236

Reconciling Volatility and the Back Spread or Ratio Spread 238

**CHAPTER 20 The Butterfly Spread 241**

Setting up a Butterfly 241

The Butterfly Spread as a Volatility Investment 245

Greek Values and the Butterfly 247

Structuring and Pricing a Butterfly 250

Trading Butterflies in a Volatile Market 250

**CHAPTER 21 Wingspreads 253**

Capturing Convergence and Divergence 253

Wingspreads: Risk/Reward 254

Wingspreads: Sensitivities 254

Wingspreads and the Greeks 255

Wingspreads: Various and Sundry Details 257

The Condor Spread 258

Conclusion 267

About the Author 269

Index 271