Introduction to the Second Edition

Since the first edition of Volatility Trading was published, the volatility markets have changed. One might think that the big change was the exceptionally volatile period at the end of 2008, followed by the long, slow decline of volatility since then. Although this has certainly made trading challenging, markets have behaved like this before and no doubt will again. This kind of change is always happening. More interesting has been the trend for exchanges to list volatility-dependent products (futures, exchange-traded funds [ETFs], and exchange-traded notes [ETNs]). This gives us new ways to make volatility trades and relative value bets. In this edition, we look at the Volatility Index (VIX) futures and ETNs, as well as leveraged ETFs.

Another major change has been the increasing effects of high frequency trading. Traders who are aggressively market-making equity options, trying to be on every bid and offer, will have to take such algorithms into account. These strategies are not covered in this book. My focus is on positional trading of volatility, and these trades generally have holding periods of days to months. These timescales are far from high frequency.

About This Book

The concepts behind this type of trading are largely unchanged, but my emphasis has probably changed slightly. Although academics have continued to work on forecasting volatility, I think the improvements from the perspective of an option trader are now marginal. For example, the profitability of equity volatility long short portfolios has declined significantly over the past five years. This would probably not be what I would choose to focus on now. So although I have slightly expanded the section on volatility forecasting, I think it is now more important than ever to look for situations where the odds are in our favor whether we can accurately measure and forecast volatility. To this end, I have added chapters on stylized facts of markets and the variance premium.

I have also expanded the chapter on psychology. The usefulness of behavioral psychology to traders is still a matter of debate. Traders themselves seem to be greatly polarized, either being true believers or completely dismissive. I make no apologies for being a believer. I know that studying this has helped me.

I see trading as a process and I've tried to write this book to be consistent with this view. It was intended to be read in the order presented. However, most chapters are self-contained and there is probably no great harm in jumping around from section to section. An exceptionally impatient reader could even gain much of the benefit of the material by just looking at the summary at the end of each chapter. Some more tangential material, mainly mathematical in nature, has been relegated to sidebars. These can probably be skipped entirely without losing continuity.

This book is about trading volatility. More specifically, it is about using options to make trades that are primarily dependent on the range of the underlying instrument rather than its direction.

Before discussing technicalities, I give a brief description of my trading philosophy. In trading, as in most things, it is necessary to have general guiding principles in order to succeed. Not everyone need agree on the specific philosophy, but its existence is essential. For example, it is possible to be a successful stock market investor by focusing on value-style investing, buying stocks with low price-to-earnings or price-to-book ratios. It is also possible to be a successful growth investor, buying stocks in companies that have rapidly expanding earnings. It is not possible to succeed consistently by randomly acquiring stocks and hoping that things just work out.

I am a trader. I am not a mathematician, financial engineer, or philosopher. My success is measured in profits. The tools I use and develop need only be useful. They need not be consistent, provable, profound, or even true. My approach to trading is mathematical, but I am no more interested in mathematics than a mechanic is interested in his tools. However, a certain level of knowledge, familiarity, and even respect is needed to get the most out of these tools.

There is no attempt here to give a list of trading rules. Sorry, but markets constantly evolve and rules rapidly become obsolete. What do not become obsolete are general principles. These are what I attempt to provide. This approach isn't as easy to digest as a list of magic rules, but I do not claim markets are easy to beat, either. The specifics of any trade are always different, but general guidelines can always point us somewhat in the right direction. Some latitude in strategy is desirable and adaptability is essential, but there are also a number of things that have to be firmly in place in order to succeed. Picasso and Braque may have broken many rules, but they could certainly paint very well technically before they did so. Similarly, before you start adjusting strategies, make sure you have a good grasp of the fundamental aspects on which all trades need to be based: edge, variance, and appropriate size.

Certain old-school traders have used arguments like: “Trading is about humans. Your models can't capture the human element.” This generally seems to be said in a defensive manner. Maybe their models can't capture the human element, but ours will capture at least part of it. Most of the reluctance of such traders to embrace quantitative techniques can be attributed to defensiveness and aversion to change. It probably isn't due to any deep aversion to quantification. After all, in the same way that traditional baseball people hate the new statistical analyses but are fine with batting average and earned run averages, many traditional option traders denigrate quantitative analysis while being perfectly happy with the Black-Scholes-Merton paradigm and the concept of implied volatility. They are probably just unwilling to admit that they need to continue to learn and are worried that their skills are becoming obsolete. They should be. We all should be. This is a continually evolving process.

However, when successful traders say something like this, we need to consider that they may be partly correct. Some traders do indeed have finely honed intuition, generally called feel when applied to market sense. Intuition exists and can even be developed, but generally not quickly. Also, just because some traders have feel does not mean all, or even many, do. The approach we develop based on mathematics and measurement can be systematically learned. Given that it can be learned, what excuse is there not to learn it? Further, while a logic-based trader may never be able to develop effective intuition, an intuitive trader can always benefit from logic-based reasoning.

Although markets are designed and populated by human traders, with their typical human emotions and foibles, there is no justification for using this as a reason to avoid quantification and measurement. Baseball is also a game played by humans, and batting average is a useful way to measure the quality of a hitter. Similarly, before making a trade we need to be able to somehow quantify the level of risk we will be incurring and the amount of edge we expect to gather. This is exactly what mathematics is good for. Estimating return and risk (however we define it) is purely a mathematical task. If something cannot be measured it cannot be managed. Further, if the human element is going to be important to our success, it will need to have measurable effects. The markets may indeed be driven by animal spirits, but I will remain thoroughly agnostic until they turn into poltergeists and start to actually throw prices around.

Pragmatism must always be our guiding philosophy. When I have had to choose between including something because I have found it useful, or omitting it because I could not prove it, I have tended to err on the side of inclusion. Successful trading is based on making correct decisions under conditions of uncertainty and incomplete information. There will always be things that we suspect are true but cannot prove. Waiting for proof may well mean waiting until the methods are no longer useful.

There are almost certainly other ways to trade options successfully. What I offer is a way, not the way. It is very much a data-driven, statistically oriented approach that should be applied over a wide range of products. But even traders who focus on one or two markets should be able to find some things useful and directly applicable. Traders who do not trade options should nevertheless find most aspects of the book useful as well.

The companion website for this book includes spreadsheets that illustrate some of the ideas presented in the book, along with the inevitable errata.

The Trading Process

Trading can be broken down into three main areas: finding profitable trades, managing risk and bankroll, and psychology. There is little to be gained by arguing over their respective levels of importance. Most traders will be more proficient in one of the three aspects than the others, but all three must be present for a trading operation to be a success.

When trading options, finding an edge involves forecasting volatility and understanding how volatility determines the market price of options. This means that we need a model for translating between price space and volatility space. Over the past 40 years, traders and financial engineers have proposed a number of option pricing models of varying complexity. We choose to use the Black-Scholes-Merton (BSM) methodology. Traders have learned to think in BSM terms. As a trader once said to me, “I...