TRADING OPTIONS IN TURBULENT MARKETS

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1 TRADING OPTIONS IN TURBULENT MARKETS Master Uncertainty through Active Volatility Management Second Edition Larry Shover BLOOMBERG PRESS An Imprint of WILEY

2 Contents Preface Acknowledgments Introduction xiii xv 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 Vll

3 viii ' Contents 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

4 Contents ' ix 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 HighrVolatility 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 Skew + Term Structure = Volatility Surface 111

5 Contents 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

6 Contents ' xi 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 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

7 xii ' Contents 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

The Option Trader Handbook

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