Arts Entertainments

How to Trade Options – Book Review – Sheldon Natenberg, Options Pricing and Volatility

As with most books on the subject of trading options, the amount of material to process can be overwhelming. For example, with Option Volatility and Pricing by Sheldon Natenberg, it’s about 418 pages to digest.

There are adequate reader reviews on Amazon and Google Book Search, to help you decide whether to get the book. For those just starting out or about to read the book, I’ve broken down the basics into the larger, more essential chapters to help you get through it faster.

The number to the right of the chapter title is the number of pages contained in that chapter. It is not the page number. The percentages represent how much each chapter makes up of the 418 total pages, excluding appendices.

1. The language of options. 12, 2.87%.

2. Elementary strategies. 22, 5.26%.

3. Introduction to Theoretical Price Models. 16, 3.83%.

4. Volatility. 30, 7.18%.

5. Use of the theoretical value of an option. 14, 3.35%.

6. Options values ​​and changing market conditions. 32, 7.66%.

7. Introduction to Diffusion. 10, 2.39%.

8. Volatility spreads. 36, 8.61%.

9. Risk considerations. 26, 6.22%.

10. Bullish and bearish spreads. 14, 3.35%.

11. Arbitration Option. 28, 6.70%.

12. Early Exercise of American Options. 16, 3.83%.

13. Coverage with Options. 16, 3.83%.

14. Revised volatility. 28, 6.70%.

15. Futures and Options on Stock Indices. 30, 7.18%.

16. Spread between markets. 22, 5.26%.

17.Position analysis. 32, 7.66%.

18. Models and the Real World. 34, 8.13%.

Focus on chapters 4, 6, 8, 9, 11, 14, 15, 17, and 18, which make up about 66% of the book. These chapters are relevant for practical business purposes. These are the key points of these focus chapters, which I am summarizing from the perspective of a retail options trader.

4 Volatility. Volatility as a measure of speed in the context of price in/stability for a given commodity in a particular market. Despite its shortcomings, the definition of volatility is still based on these assumptions of the Black-Scholes model:

1. The price changes of a product remain random and cannot be designed, which makes it impossible to predict the direction of the price before its movement.

2. Percentage changes in product price are normally distributed.

3. Because product price percentage changes are counted as continuous compounding, the product price at expiration will follow a log-normal distribution.

4. The mean of the lognormal distribution (reversion to the mean) is found in the forward price of the product.

6 Option values ​​and changing market conditions. Use of Delta in its 3 equivalent forms: Exchange Rate, Hedging Ratio and Theoretical Equivalent of the Position. Treatment of Gamma as the curvature of an option to explain the opposite relationship of OTM/ITM strikes with the ATM strike having the highest Gamma. This is the inverse Theta-Gamma relationship, as well as Theta being synthetically intertwined as a long drop and short premium with the implied volatility, as measured by Vega.

8 volatility spreads. The emphasis is on the sensitivities of a Ratio Back Spread, Ratio Vertical Spread, Straddle/Strangle, Butterfly, Calendar and Diagonal to interest rates, dividends and the 4 Greeks with specific attention to the effects of Gamma and Vega.

9 Risk considerations. A sobering reminder to select spreads with the lowest aggregate risk spread versus the highest probability of profit. Aggregate risk measured in terms of Delta (directional risk), Gamma (curvature risk), Theta (downside/premium risk) and Vega (volatility risk).

11 Arbitration Option. Synthetic positions are explained in terms of building a risk profile equivalent to the original spread, using a combination of single options, other spreads and the underlying product. Clear warning that the transformation of operations in Conversions, Reversals and Adjustments is not without risk; but it may increase the shorter-term risks of the trade while reducing the longer-term net risk. There are important differences in the cash flows of long vs. short options, arising from unique product bias bias and the interest rate built into call options, making them disparate vs. sale.

14 Revised volatility. The different expiration cycles between short-term options and long-term options create an average of long-term volatility, a medium volatility. When volatility rises above its mean, there is a relative certainty that it will return to its mean. Likewise, mean reversion is very likely as volatility falls below its mean. The twist around the mean is an identifiable feature. The discernible volatility characteristics make it essential to forecast volatility over 30-day periods: 30-60-90-120 days, as the typical timeframe is short credit spreads between 30-45 days and long debit spreads between 90 days. -120 days. Reconcile implied volatility as a measure of the consensus volatility of all buyers/sellers of a given product, with inconsistencies in historical volatility and predictive constraints on future volatility.

15 Stock Index Futures and Options. Effective use of indexing to de-risk individual stocks. Different treatment of risks for equity-settled indices (including the impact of dividends/exercise) separate from cash-settled indices (non-dividend/exercise). It explains the logic for the theoretical price of stock index futures options, as well as the price of the futures contract itself, to determine which is economically viable to trade: the futures contract itself or the options on the futures.

17 Analysis of positions. A more robust method than simply looking at the Delta, Gamma, Vega and Theta of a position is to use the relevant theoretical price model (Bjerksund-Stensland, Black-Scholes, Binomial) to test the scenario of changes in dates (daily/weekly ) before expiration, percentage changes in implied volatility and price changes within and close to +/- 1 standard deviation. These factors that feed into the scenario tests, once plotted, reveal the relative proportions of Delta/Gamma/Vega/Theta risks in terms of their proportionality impacting the Theoretical Price of specific strikes that make up the construction of a spread.

18 models and the real world. It addresses the weaknesses of these core assumptions used in a traditional pricing model: 1. Markets are not fluid: buying/selling an underlying contract is constrained in terms of tax implications, financing limitation, and transaction costs. 2. Interest rates are variable, not constant over the life of the option. 3. Volatility is variable, not constant over the life of the options. 4. Trading is not continuous 24/7: There are exchange holidays that lead to gaps in price changes. 5. Volatility is linked to the Theoretical Price of the underlying contract, it is not independent of it. 6. The percentage of price changes in an underlying contract does not result in a lognormal distribution of the underlying prices in the distribution due to Skew & Kurtosis.

To conclude, reading these chapters is not academic. Understanding the techniques discussed in the chapters should enable you to answer the following key questions. In the total inventory of your business account, if you are:

  • Net Long more Calls than Puts, have you forecast Implied Volatility (IV) to rise, expecting the prices of the products traded in your portfolio to rise?
  • Net Long more Puts than Calls, have you forecast IV to rise, expecting traded product prices to decline?
  • Net Long an equal number of Calls and Puts, have you forecast IV to rise, expecting prices to drift non-directionally?
  • Net Short more Calls than Puts, have you predicted that IV will fall? but wait for prices to drop?
  • Net Short more Puts than Calls, have you predicted that IV will fall? but wait for prices to rise?
  • Net Short an equal amount of Calls and Puts, have you predicted that IV will drop? but do you expect prices to drift non-directionally?

Leave a Reply

Your email address will not be published. Required fields are marked *