Positional Option Trading

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.

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

Euan Sinclair, PhD, is an options trader and financial engineer at Hull Tactical. He holds a doctorate in theoretical physics from the University of Bristol.

Created for experienced traders who desire the significant benefits of including options in their trading strategies and portfolios, Positional Option Trading: An Advanced Guide shows readers how to find a trading situation with an edge, structure a trade, and control the risk.

Written in three parts, the first section of Positional Option Trading discusses the efficient market hypothesis and how, even if we accept it as true, it leaves plenty of room for the discovery of profitable trading strategies. These opportunities can be categorized as inefficiencies or risk premia, each of which should be traded differently. The author also discusses behavioral psychology and its ability to inform our strategies. Technical and fundamental analysis are explored as ways of finding trading edges.

Forecasting, as well as the overpricing of implied volatility are examined in the next chapters, while the section closes with a description of eleven specific phenomena that can be profitably traded.

The second part of the book discusses the distributional properties of some option structures used to monetize the trading edges revealed by the previously discussed techniques. Volatility trading structures and directional option trades are examined next.

Finally, the third part of Positional Option Trading discusses the concept of risk generally. The book closes with a description of specific topics like trade sizing and the idea of unknowable risks, using historical examples as a guide.

Perfect for moderately to highly experienced traders who hope to use option trading to reduce risk and increase returns in their trading strategies, Positional Option Trading belongs on the bookshelves of professional traders and money managers as well as those who wish to maximize the efficiency of their own portfolios.

Praise for POSITIONAL OPTION TRADING

"Euan Sinclair's book provides an investor with a systematic quantitative approach for using options to enhance returns. Sinclair has worked for over 25 years in the options industry with two of the most successful market making firms. Drawing from his vast experience he exposes tricks of the trade that were previously only available to professionals or exchange members."
—Blair Hull, Founder and Chairman, Hull Tactical Asset Allocation

"This book is another excellent example of Sinclair's in-depth understanding of derivatives markets. Chapter 10 alone is worth the price of the book; it deftly explains the real-world pitfalls that one usually learns about only after suffering losses. With astute analysis, Sinclair guides his readers through the complex world of derivatives markets."
—Arthur Duquette, Partner, Bluefin Trading

"Volatility trading is asymmetrically difficult either on the short side or on the long side. In recent years we have seen both long and short volatility shops going out of business ... Euan Sinclair manages to relay a strong message that the difference lies in finding trades with positive expected value, not with the sign of your trades. He proposes to analyze the term structure, fundamental factors, and earnings for edges. He suggests evaluating the skewness and trade sizing to monetize the edges. This book is a must-read full of knowledge for anyone working with and learning about options markets!"
—Artur Sepp, Director of Research, Quantica Capital AG