The Option Trader’s Hedge Fund
By Dennis A. Chen and Mark Sebastian
FT Press, 2012
$49.99, 219 pages
The business framework the authors have in mind for option trading operations is that of an insurance company. It is easy to see the comparison when both forms of business charge a premium for accepting and managing risk. Chen and Sebastian call the business TOMIC, “The One Man Insurance Company.” They show that all of the insurance company functions, such as underwriting, pricing, reinsurance and claims processing may be matched by an options trader selecting securities, managing risk, collecting option premiums and buying protective calls or puts.
The level of intensity varies from the beginning of the book to the end, starting with general characteristics of insurance companies compared with options trading through the first seven chapters. From that point through the remaining eight chapters and four appendices, descriptions of complex options trades, volatility, skewness, gamma and other details provide a mini-course on option pricing and trading. To fully appreciate this book, the reader should have — as cautioned by the authors — previous knowledge of options and options trading.
TOMIC selection of markets (managing underwriting risk) includes indexes, exchange-traded funds and equities. Individual futures contracts are not included, but may be accessed through commodity indexes or exchange-traded commodities. Several pages are devoted to lists of available securities, selection techniques, time frames, volatility and pricing.
The topic of risk management has its own lists of actions before, during and after a trade. It is recommended that a trade be terminated when a loss exceeds a predetermined arbitrary percentage of the amount traded, and that the sizes of trades be carefully planned along with diversification. Adjustments to a trade are shown to be necessary to protect capital and minimize losses.
Various types of reinsurance are available to TOMIC, including buying out-of-the-money calls on the Chicago Board Options Exchange Volatility Index (VIX) to protect a trade in a market index, assuming that a large drop in the market would cause a spike in the VIX. Buying out-of-the-money puts on the S&P 500 is another protective device. Ultimately, the authors say that “units can save your portfolio.” A unit is defined as an “inexpensive option with unpredictable Greeks.”
A unit may have delta lower than 5, while protection occurs when the market makes a large downward move. Because of market action by traders rushing to buy puts, the unit (usually in the front month for a larger response) increases in value to fulfill its protective role. Chen and Sebastian recommend using 5% to 10% of the funds allocated for spread trades such as condors, butterflies and time spreads on the purchase of units.