Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management

260 Pages·2010·2.72 MB·English

by  Larry Shover(auth.)

TRADING
OPTIONS IN
TURBULENT
MARKETS
Master Uncertainty through Active
Volatility Management
L S
ARRY HOVER
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Copyright © 2010 by Larry Shover. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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10 9 8 7 6 5 4 3 2 1
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Contents
Acknowledgments ix
Introduction xiii
Part One: Understanding the Relationship between Market
Turbulence and Option Volatility 1
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 8
The Six Benefi ts of Options 9
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 20
How Volatility Really Works on the Trading Floor 21
Volatility and Uncertainty: Lessons for
the Irrational Option Trader 22
Varieties of Option Volatility Trading 23
iii
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iv Contents
3 Working with Volatility to Make
Investment Decisions 25
On Predicting the Future 25
Starting with Historical Volatility 27
Implied Volatility 33
Why Do Volatilities Increase as Equities Fall? 36
Implied Versus Historical Volatility 37
Justifi cation for the Disparity Between Historical and
Implied Volatility 38
4 Volatility Skew: Smile or Smirk? 41
Considering Some Examples 42
A Primer on Random Walk and Normal Distribution 43
Dealing with the Higher Moments of the Normal Distribution 48
Skew Is High, Skew Is Low. So What? 50
Does a “Flat” or “Steep” Skew Predict the Future? 51
A Fair Warning About Thinking About Skew Too Much 51
Part Two Understanding Option Volatility and its
Relationship to Option Greeks, Personal Decision
Making, and Odds Creation 53
5 Extreme Volatility and Option Delta 55
The Misnomer of Delta and Probability of Exercise 55
Delta Defi ned 57
The Relationship Between Volatility and Delta 61
Higher Volatility and Delta 62
Lower Volatility and Delta 63
Delta, Time, and Volatility 63
Delta, Position Delta, Volatility, and the Professional Trader 64
6 Smoke and Mirrors: Managing Gamma
through Volatile Markets 69
Gamma and Volatility 72
Managing Positive Gamma during a
High-Volatility Environment 73
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CONTENTS v
The Bad News: There’s Always More than Meets the Eye 74
Practical Considerations for Managing Long Gamma
in a High-Volatility Environment 75
Managing Negative Gamma in a High-Volatility Environment 76
Practical Considerations of Negative Gamma in High Volatility 78
Gamma and Volatility with Respect to Time Structure 79
Summary 81
7 Price Explosion: Volatility and Option Vega 83
The Relationship between Implied Volatility and Vega 84
Implied Volatility: Price Analogy 86
Option Vega and Time 86
Option Vega and Its Greek Cousins 86
Option Vega Implications 87
Don’t Underestimate the Relationship between Volatility
and Option Vega 88
Volatility and Vega Insensitivity 90
Important Concepts When Applying Option Vega in a Volatile
Marketplace 91
Summary 94
8 Sand in the Hourglass: Volatility and Option Theta 95
Balancing Time Decay with Volatility: Mistakes Traders Make 97
Volatility and Theta: What Every Investor Needs to Know 102
Part Three Ten Proven Strategies to Employ in
Uncertain Times 107
9 Preparing for Trading Using Volatility Strategies 109
The Elements of a Sound Trading Decision 110
Developing an Approach to Options Trading 111
The Mind of a Successful Trader 114
Decision Making, Options versus Everything Else 117
10 The Buy-Write, or the Covered Call 119
The Buy-Write (Covered Call) Defi ned 119
An Example of the Covered Call Strategy 120
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vi Contents
The Theory and Reality of the Covered Call 121
Covered Call Writing and Implied Volatility 125
Implied Volatility in Practice 126
Managing Contracts in a Time of High Volatility
or a Falling Market 131
Effective Call Writing in a Volatile Market 132
11 Covering the Naked Put 135
Contemplating the Cash-Secured Put 138
Utilizing the Cash-Secured Put in a High-Volatility
Environment 140
Cash-Secured Put and Volatility: Risks and Consequences 142
Income Strategy: Volatility as an Asset Class and
Cash-Secured Puts 144
Position Management 146
12 The Married Put: Protecting Your Profi t 149
Volatility, Downside Risk, and the Case for
Portfolio Insurance 149
Why Buy High Volatility? 150
The Married Put 151
How and When to Use a Married Put 153
Example of When to Use a Married Put 154
The Married Put: Limiting Loss, Neutralizing
Volatility, and Unleashing Upside Potential 157
Married Put: A Real-Life Illustration 158
13 The Collar: Sleep at Night 161
Collar Strategy 161
Types of Collars 165
Summary 170
Conclusions on the Collar Strategy 174
14 The Straddle and Strangle: The Risks and
Rewards of Volatility-Sensitive Strategies 179
The Buying or Selling of Premium 180
Properties of Straddles and Strangles 180
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CONTENTS vii
Comparing Straddles and Strangles 182
How to Compare Historical and Implied Volatility 184
The Impact of Correlation and Implied Volatility Skew 185
An Alternative to the Naked Volatility Sale via the
Straddle/Strangle: The Strangle Swap 187
15 The Vertical Spread and Volatility 193
Introduction to the Vertical Spread 194
A Trader’s Reasoning for Trading a Vertical Spread 196
Designing Your Vertical Spread 198
Vertical Spreads and Greek Exposure 201
Vertical Spreads as a Pure Volatility Play 204
Comparing Volatility’s Effect on Vertical Spreads 205
Summary: Comparing Vertical Spreads and Implied Volatility 206
16 Calendar Spreads: Trading Theta and Vega 209
Calendar Spreading—Trading Time 210
Risks and Rewards of the Calendar Spread 211
A Calendar Spread with a Bullish Expectation 213
Considerations and Observations for Calendar
Spreads and Volatility 214
17 Ratio Spreading: Trading Objectives Tailor Made 219
How Back Spreads and Ratio Spreads Work 219
Back Spreads 221
Ratio Spreads 223
Greek Values and the Back Spread or Ratio Spread 225
Confi guring and Pricing a Back Spread or Ratio Spread 229
Reconciling Volatility and the Back Spread or Ratio Spread 231
18 The Butterfl y Spread 233
Setting up a Butterfl y 233
The Butterfl y Spread as a Volatility Investment 237
Greek Values and the Butterfl y 239
Structuring and Pricing a Butterfl y 242
Trading Butterfl ies in a Volatile Market 243
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viii Contents
19 The Iron Butterfl y and the Condor 245
The Iron Butterfl y 246
The Condor 248
The Iron Butterfl y, the Condor, and a Volatile Marketplace 249
Index 251
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Acknowledgments
I Would like to start by saying thank you to the hundreds of brokers,
traders, clerks, and exchange personnel with whom I’ve shared both the
opportunity and privilege to grow and learn as a trader over the years.
Spending countless hours jammed shoulder-to-shoulder with other trad-
ers and trading staff produces a bond—a familial link—that transcends
both emotions and time. I started in this industry as an 18-year-old boy.
Now, looking back, I refl ect on the lessons learned, the emotions, the
broken dreams, the vast fortunes made and lost, as well as the raging
hostility of my fellow traders at times, and the fear. All of this I have sub-
tly collected and fi led away. The ink spilt during the writing of this book
is the result of this experience, and for that I am most grateful.
A very special thanks to my editor, Stephen Isaacs, of Bloomberg
Press. Stephen’s phone was never far away. He provided me with ongo-
ing encouragement, guidance, and support. To Kevin Commins of John
Wiley & Sons, who continuously shared my enthusiasm for the book and
guided me through its transformation.
Jim Bittman of the CBOE and Options Institute is, in my opin-
ion, the industry’s most interesting and capable instructor on options
trading. Jim has written two very successful books and was always very
encouraging and supportive of my writing efforts. I’m thankful to have
a friend like Jim to emulate.
Curt Zuckert of the CME Group’s Trading Knowledge Center
(TKC) regularly greeted me with a smile even though he knew full well
that my only intention was to camp out in his “library,” using it as my
ix
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x Acknowledgments
personal offi ce (and for my personal gain) while researching this project.
Although I had plenty of places where I could have gone to write, the
energy of TKC gave me hope and inspiration.
A special thanks to my pre-editors Eve Bradshaw and Anna Dyer.
Eve helped springboard both me and this project with her thoughtful
advice and timely encouragement. Eve is a true confi dant. I’m thankful
for personally benefi ting from Anna’s talent as a professional editor.
Thanks to two deeply helpful counselors for this work, Carol King
and Sharon Durling. Carol’s photographic skill is unparalleled, and
her personal applause meant a great deal to me. Sharon, a published
author and family friend, was always ready for the sundry questions that
came her way. I’m truly blessed to have an audience of someone who
has walked ahead of me in the writing world.
Matthew Curtis did nothing short of rescue me from my technical
defi cit by designing and editing most of the initial charts and graphs.
I count myself fortunate to be able to defer to Matthew, coming to
him mostly empty handed while returning with a stunning piece of art.
Matthew saved me from countless failed and frustrated efforts.
A very big thanks to my chief technical writer, Mark Dawson. Mark
is not only one of the greatest technical writers in the trading fi eld, he
also carries a sixth sense. Mark had a continuous feeling for where this
book was headed and kept me paddling in the right direction. When
I ran out of ink, Mark was there—he possessed an uncanny ability to
keep me focused on the book, its intention, and the audience I hope
to reach.
Thanks to Kay D. Wright who, while as a high school student
working at the inkstand, instilled me with the confi dence and enthu-
siasm to write. I give Mrs. Wright particular mention as an encour-
agement to her and all teachers alike. Over 25 years have passed since
I’ve been under Mrs. Wright’s tutelage, yet her inspiration continues to
whisper in my ear.
Very special thanks to my mother, Carol Blackwell, who I recall
from a very young age persuading me to keep writing. She has always
been lavishly wasteful with her thoughtful words of encouragement,
no matter how poorly my latest half-baked rag was written. I can hon-
estly say that I would not have put pen to paper without her unwavering
support.
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