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.
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.