Sheldon Natenberg - Option Volatility and Pricing: Advanced Trading Strategies and Techniques, 2nd Edition

Copyright 2015 by Sheldon Natenberg. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

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To Leona, for her support and encouragement throughout my career .

To Eddie, who continually makes me proud to be a father .

Contents

Preface

It probably seems strange for an author to wait 20 years to revise a professional publication, especially one that has been continuously in print over the entire period. To those of you who were hoping for at least one revision in the intervening years, I can only offer my apology and the excuse that other obligations prevented me from undertaking such a revision.

Much has changed in option markets over the last 20 years. Most markets are now fully electronic, and the days of floor trading are clearly numbered. Only in the United States do option-trading floors still exist, and even those are inevitably giving way to electronic trading. Twenty years ago, organized option markets existed only in the major industrialized nations. But as the importance of derivatives as both an investment vehicle and a risk-management tool has become widely recognized, new option markets have opened in countries around the world. Options are now traded not only on traditional productsstocks, interest rates, commodities, and foreign currenciesbut also on a bewildering array of new productsreal estate, pollution, weather, inflation, and insurance. Many exchanges have also added variations on traditional productsshort-term and midcurve options, flex options, options on spreads, and implied and realized volatility contracts.

Not only has there been a dramatic increase in the number of option markets, but the traders in those markets have become increasingly sophisticated. When this text was first published, knowledgeable traders could only be found at firms that traded derivatives professionallymarket-making firms, hedge funds, investment banks, and other proprietary trading firms. Now, many retail customers have a level of knowledge equal to that of a professional trader. At the same time, universities are adding or expanding programs in financial engineering. In many cases, those who choose a career in derivatives trading have already had in-depth exposure to the mathematics of option pricing.

While much has changed in the last 20 years, much has also remained the same. There is still a core body of material that a serious option trader needs to master, and this core material is much the same as it has always been. The previous edition of this text was an attempt to present this material in a manner that was easily accessible and that did not require a familiarity with advanced mathematics. This edition retains that approach. Although some presentations may have been changed in the interest of improving an explanation or clarifying a concept, all the major topics from the previous edition have been retained.

So whats new in this edition? As in the first edition, an attempt has been made to explain important concepts in the simplest possible manner using an intuitive rather than mathematical approach. However, it is also true that a full understanding of many option concepts requires a familiarity with more advanced mathematics. Consequently, some explanations have been expanded to include a discussion of the relevant mathematics. But even these discussions tend to avoid mathematical concepts with which many readers are unlikely to be familiar. Many chapters have also been expanded to include a more detailed discussion of the relevant topics. In addition, there are several completely new chapters covering forward pricing, risk dynamics, the Black-Scholes model, binomial option pricing, and volatility contracts.

As with any living language, market terminology, and more specifically, option terminology, has changed over time. Some terms that were common when the first edition appeared have gone out of favor or disappeared completely. Other terms that did not previously exist have gained wide acceptance. This is reflected in small changes to the vocabulary used in this text.

It is almost impossible to keep up with the amount of information that is available on options. Not only do new books appear with greater frequency, but the Internet has enabled traders to find relevant source material almost instantaneously. For this reason, the Bibliography has been eliminated. This should not be construed as an attempt to discourage readers from consulting other sources. This book represents only one approach to optionsthat of a professional trader. Many excellent option books are available, and any aspiring option trader will want to consult a broad range of texts in order to understand the many different ways one can approach option markets. For those who are interested in the mathematics of option pricing, this text is in no way meant to take the place of a good university textbook on financial engineering.