Volatility Trading

Introduction 1 The Trading Process 3 CHAPTER 1 Option Pricing 7 The Black-Scholes-Merton Model 7 Summary 14 CHAPTER 2 Volatility Measurement and Forecasting 15 Defining and Measuring Volatility 15 Definition of Volatility 16 Alternative Volatility Estimators 22 Close-to-Close Estimator 26 Parkinson Estimator 26 Garman-Klass Estimator 27 Rogers-Satchell Estimator 27 Yang-Zhang Estimator 27 Using Higher-Frequency Data 27 Forecasting Volatility 31 Maximum Likelihood Estimation 36 Forecasting the Volatility Distribution 39 Summary 43 CHAPTER 3 Implied Volatility Dynamics 45 Volatility Level Dynamics 48 Informal Definition 50 More Formal Definition 50 A Traders' Definition 50 Smile Dynamics 54 Summary 62 CHAPTER 4 Hedging 63 Ad Hoc Hedging Methods 65 Hedging at Regular Intervals 65 Hedging to a Delta Band 65 Hedging Based on Underlying Price Changes 65 Utility-Based Methods 66 The Asymptotic Solution of Whalley and Wilmott 71 The Double Asymptotic Method of Zakamouline 74 Estimation of Transaction Costs 78 Aggregation of Options on Different Underlyings 83 Summary 85 CHAPTER 5 Hedged Option Positions 87 Discrete Hedging and Path Dependency 87 Volatility Dependency 93 Summary 99 CHAPTER 6 Money Management 101 Ad Hoc Schemes 101 The Kelly Criterion 103 Alternatives to the Kelly Criterion 113 Trade Sizing in a Continuously Changing Setting 118 A Simple Approximation 124 Summary 126 CHAPTER 7 Trade Evaluation 127 General Planning Procedures 128 Risk-Adjusted Performance Measures 134 The Sharpe Ratio 135 Alternatives to the Sharpe Ratio 137 Setting Goals 140 Persistence of Performance 142 Relative Persistence 143 Absolute Persistence 144 Summary 147 CHAPTER 8 Psychology 149 Self-Attribution Bias 151 Overconfidence 152 The Availability Heuristic 155 Short-Term Thinking 156 Loss Aversion 157 Conservatism and Representativeness 158 Confirmation Bias 160 Hindsight Bias 161 Anchoring and Adjustment 162 Summary 162 CHAPTER 9 Life Cycle of a Trade 165 Pretrade Analysis 165 June 25, 2007 165 June 26, 2007 169 June 27, 2007 169 June 28, 2007 170 June 29, 2007 170 July 2, 2007 170 July 3, 2007 170 Post-Trade Analysis 171 Summary 173 CHAPTER 10 Conclusion 175 Execution Ability 176 Concentration 177 Product Selection 177 Appendix A: Model-Free Implied Variance and Volatility 179 The VIX Index 180 Appendix B: Spreadsheet Instructions 183 GARCH 183 Volatility Cones and Skew and Kurtosis Cones 184 Daily Option Hedging Simulation 184 Trade Evaluation 185 Trading Goals 185 Corrado-Su Skew Curve 185 Mean Reversion Simulator 186 Resources 187 Essential Books 187 Thought-Provoking Books 189 Useful Web Sites 190 References 193 About the CD-ROM 201 Index 203