From the December/January 2013 issue of Futures Magazine • Subscribe!

The Option Trader’s Hedge Fund

Book Review

The authors devote a chapter to understanding volatility. They emphasize volatility as the primary determinant of success in trading options, with forward volatility the only unknown factor among the five pricing variables: Underlying price, strike price, time to expiration, cost of carry and forward volatility. It is shown that options with very low delta values cease to have measurable volatility, but they do have extreme price risk for the short-seller and are valuable as net long protective units.

While the authors are correct in stating that volatility is an output of the pricing model, not an input, this can refer only to the measurement of volatility implied by models such as Black-Scholes — that is, the one pricing factor that must be filled in so that the model’s price matches the current market price. Actual volatility — the market’s prediction of future price variation — is an input to all option prices and the only reason for any option to have value. 

For an experienced trader, the chapter on the most-used strategies will probably be considered the core of the book. Five strategies are described: Vertical spread, iron condor, ATM iron butterfly, calendar or time spread, and ratio back and front spread. Along with a detailed description and example trade, each strategy is accompanied by the market conditions that are most favorable for its use together with goals, major risks and ideas for adjustment techniques. 

The charts shown for the five strategies are useful especially in understanding the numerical set-ups and results. The authors add many nuggets of advice on trading, pricing and risk management. The insurance company seems to be left in the background and is replaced in this chapter by out-and-out, high-quality option trades.

Following their favorite strategies, Chen and Sebastian return to TOMIC, writing notes on trading plans, executing the trading plan and risk management parameters. Three of the final chapters are based on the experience of the authors: Lessons from the trading floor on volatility, risk management, trading and execution, and on “the other Greeks.” Examples include the larger-than-expected delta sensitivity of an iron condor when implied volatility increases and the need to weight an option portfolio according to price or size.

The last experience-related discussion is on gamma scalping, from a blog by Mark Sebastian. Included in the description is delta/gamma ratio hedging. The authors confirm that gamma scalping is not for most retail traders unless they have a very strong understanding of the mechanics. This comment is true for any reader of this book. With some previous knowledge the reader is sure to gain information and more experience on paper before trying out the trades and TOMIC management plans.

Paul Cretien is an investment analyst and financial case writer. His email is PaulDCretien@aol.com.

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