Trading Volatility, correlation, term structure, and skew 2014!!

317 Pages·2014·4.82 MB·English

by  Colin Bennett

Trading Volatility, Correlation,
Term Structure and Skew
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“A master piece to learn in a nutshell ABOUT
all the essentials about volatility with
a practical and lively approach.
THE
A must read!”
Carole Bernard, Equity Derivatives
Specialist at Bloomberg T
AUTHOR
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“This book could be seen as the
‘volatility bible’!”
Colin Bennett is a Managing Director and A
Markus-Alexander Flesch, Head of
Head of Quantitative and Derivative Strategy
Sales & Marketing at Eurex
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at Banco Santander. Previously he was Head
“I highly recommend this book both of Delta 1 Research at Barclays Capital, and I
for those new to the equity derivatives Head of Convertible and Derivative Research N
business, and for more advanced at Dresdner Kleinwort.
readers. The balance between theory G
and practice is struck At-The-Money” Colin started his career in Convertible Bond
Paul Stephens, Head of Institutional Research at Merrill Lynch, after studying
Marketing at CBOE V
Mathematics and Electrical Engineering at
Cambridge University. In the 1993 National
O
“One of the best resources out there
Mathematics Contest Colin came 16th in the
for the volatility community”
UK. He has also worked in Equity Derivative
Paul Britton, CEO and Founder of
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Sales, and as a Desk Analyst for the equity
Capstone Investment Advisors
derivative trading desk.
A
“Colin has managed to convey Colin is a regular speaker at CBOE, Eurex,
often complex derivative and T
Marcus Evans, Futures and Option World, Risk
volatility concepts with an admirable
Magazine and Bloomberg conferences.
simplicity, a welcome change from I
the all-too-dense tomes one usually L
finds on the subject” www.trading-volatility.com
Edmund Shing PhD, former Proprietary I
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Trader at BNP Paribas
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“In a crowded space, Colin has
supplied a useful and concise guide”
Gary Delany, Director Europe at the
Options Industry Council
Any questions regarding the content of this book can be emailed to [email protected].
TRADING VOLATILITY

Trading Volatility, Correlation,
Term Structure and Skew

Colin Bennett
Copyright © 2014 Colin Bennett

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise without written permission of the publisher or author.

Trading Volatility: Trading Volatility, Correlation, Term Structure and Skew

ISBN-13: 978-1499206074

Cover Design by Gareth Allen
ACKNOWLEDGEMENTS

I would like to thank James Peattie for persuading me to work at Merrill Lynch, and starting
my career within research which I still enjoy to this very day.

Iain Clamp aka “The Guru” deserves special recognition, for explaining the intricacies of
volatility trading.

I will always be grateful to Tom Dauterman and Irene Ferrero for their many months of
effort proofing this publication. I would also like to thank Mariano Colmenar, without
whose support this book would never have been published.

And finally, and most importantly, I would like to thank my wife Claire for her endless
patience and understanding with me while I researched and wrote this book over the past 5
years.

NOTE ON CONTENTS

While there are many different aspects to volatility trading, not all of them are suitable for all
investors. In order to allow easy navigation, the sections are combined into seven chapters
that are likely to appeal to different parts of the equity derivatives client base. The earlier
chapters are most suited to equity investors, while later chapters are aimed at hedge funds
and proprietary trading desks. The Appendix contains reference material and mathematical
detail that has been removed from earlier chapters to enhance readability.
CONTENTS

PREFACE ........................................................................................................... i

CHAPTER 1
OPTIONS ................................................................................................................. 1
1.1: Option basics ........................................................................................................................ 2
1.2: Option trading in practice .................................................................................................... 4
1.3: Maintenance of option positions ..................................................................................... 11
1.4: Call overwriting ................................................................................................................... 15
1.5: Protection strategies using options .................................................................................. 23
1.6: Option structures trading .................................................................................................. 31

CHAPTER 2
VOLATILITY TRADING ..................................................................................... 35
2.1: Volatility trading using options ........................................................................................ 36
2.2: Variance is the key, not volatility ..................................................................................... 49
2.3: Volatility, variance and gamma swaps ............................................................................. 52
2.4: Options on variance ........................................................................................................... 68

CHAPTER 3
WHY EVERYTHING YOU THINK YOU KNOW ABOUT VOLATILITY
IS WRONG ............................................................................................................. 73
3.1: Implied volatility should be above realized volatility .................................................... 74
3.2: Long volatility is a poor hedge ......................................................................................... 77
3.3: Variable annuity hedging lifts long-term vol .................................................................... 81
3.4: Structured products vicious circle .................................................................................... 83
3.5: Stretching black-scholes assumptions ............................................................................. 89

CHAPTER 4
FORWARD STARTING PRODUCTS AND VOLATILITY INDICES .............. 99
4.1: Forward starting products ............................................................................................... 100
4.2: Volatility indices ................................................................................................................ 109
4.3: Futures on volatility indices ............................................................................................ 115
4.4: Volatility future ETN/ETF ............................................................................................ 122
4.5: Options on volatility futures ........................................................................................ 129
CHAPTER 5
LIGHT EXOTICS ................................................................................................. 133
5.1: Barrier options .................................................................................................................. 134
5.2: Worst-of/best-of options................................................................................................ 140
5.3: Outperformance options ................................................................................................. 143
5.4: Look-back options ........................................................................................................... 146
5.5: Contingent premium options ......................................................................................... 148
5.6: Composite and quanto options ...................................................................................... 149

CHAPTER 6
RELATIVE VALUE AND CORRELATION TRADING ................................... 153
6.1: Relative value trading ....................................................................................................... 154
6.2: Relative value volatility trading ....................................................................................... 158
6.3: Correlation trading ........................................................................................................... 161
6.4: Trading earnings announcements/jumps ..................................................................... 178

CHAPTER 7
SKEW AND TERM STRUCTURE TRADING ................................................... 183
7.1: Skew and term structure are linked ............................................................................... 184
7.2: Square root of time rule can compare term structures and skews............................ 193
7.3: Term structure trading ..................................................................................................... 198
7.4: How to measure skew and smile .................................................................................... 201
7.5: Skew trading ...................................................................................................................... 210

APPENDIX
A.1: Local volatility .................................................................................................................. 230
A.2: Measuring historical volatility ........................................................................................ 232
A.3: Proof implied jump formula .......................................................................................... 245
A.4: Proof var swaps can be hedged by log contract (=1/k2) .......................................... 248
σ
A.5: Proof variance swap notional = vega/2 ................................................................ 250
A.6: Modelling volatility surfaces........................................................................................... 251
A.7: Black-scholes formula ..................................................................................................... 255
A.8: Greeks and their meaning .............................................................................................. 257
A.9: Advanced (practical or shadow) greeks ......................................................................... 262
A.10: Shorting stock by borrowing shares ........................................................................... 266
A.11: Sortino ratio .................................................................................................................... 269
A.12: Capital structure arbitrage ............................................................................................ 270
INDEX .................................................................................................................... 286