Adam Warner - Options Volatility Trading

Copyright 2010 by Adam Warner. 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 data base or retrieval system, without the prior written permission of the publisher.

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To Susan, Jamie and Josh
for your love and support.

To Mom:
In my thoughts.
Always.

V olatility affects all types of trading, whether you ever lay your eyes on an options screen or not. This book will both help deconstruct some commonly held myths about options and volatility, as well as teach readers how to manage and profit from them.

Awareness of the whole concept of volatility has grown by leaps and bounds over the past decade. Unfortunately, so has the misunderstanding of what it all means. Options Volatility Trading will show you how to best measure volatility and how to manage an active account or an investment portfolio in a world of ever-changing risk premiums. And you might actually have some fun doing it!

Numbers? Weve got numbers. You will learn some factoids about The CBOE Volatility Index, affectionately known as the VIX that you never even thought to ask. What days of the week or the expiration cycle might make sense to look for certain types of trades? What happens to volatility at different times of the year or around holidays? Or on different days of the week?

You will see plenty of data suggesting different seasonal plays, ideas of what to do when volatility does X and the put/call does Y, and so on. But this is not a systems book; its a concepts book. Were not here to just give away the fish, as if there was such a simple fish to begin with. Were here to teach you how to fishminus an overabundance of fishing and hunting and poker-playing clichs like the one I just used.

Dont get me wrong, I love to read studies along the lines of, When we see such and such backdrop, the market has risen 14 of the last 17 times over the next two weeks, and so on. The trick though is not finding and exploiting pot odds like these; its handling trades and positions when you get those rare outliers.

I frequently omitted 2008 as part of my statistical work. Why? Well, partly because I would waste everyones time putting a caveat on every statistical observation with, If we eliminate 2008, we see a very different picture. Consider this one big caveat. Including 2008, of course, provides the most complete and correct pictureif our only goal was to produce a series of hard and fast rules. Its not. We strive more for guidelines, knowledge that perhaps you throw into your tool set when making trading decisions in any given market.

Volatility analysis always revolves around an assumption of mean reversion, that is, a tendency of moves in one direction to ultimately revert to some sort of perceived mean. But mean reversion is an amorphous concept. The same way that there is no one single correct Price-to-Earnings ratio or price-to-book valuation or any valuation metric, theres no correct VIX. Sure, we can get average and median readings over any time frame. But means themselves fluctuate. The year 2008 was about a worldwide diversion from the mean of any and all asset classes. The lesson to me was not that rules stopped working but rather it was that we should always be cognizant that rules can stop working at any time. And we need to trade and invest accordingly.

Volatility proved no different from pretty much any asset class. The key to earning money, or even staying afloat, in 2008 was not adherence to any sort of probabilistic system but rather ability to recognize precisely that heretofore reliable systems were all on tilt.

Many VIX and generalized volatility observations in the book confirm anecdotal observations from my 20-plus year career in trading options. But many debunk them as well. And to some extent they debunk what seems like common sense. Buy-writing was, is, and will probably always be the most popular use of options. Since that involves shorting an option, common sense says that it behooves the trader to sell at an objectively high volatility. But that may ultimately prove misguided from many angles. We will explore when buy-writes work best, in the expiration cycle and in certain moves in volatility.