Adam S. Iqbal - Volatility: Practical Options Theory

1. Chapter 2

1. Chapter 1
2. Chapter 2
3. Chapter 3
4. Chapter 4
5. Chapter 5
6. Chapter 6
7. Chapter 7
8. Chapter 8
9. Chapter 10
10. Chapter 11
11. Appendix A

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ADAM S. IQBAL

Copyright 2018 by Adam S. Iqbal. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress CataloginginPublication Data

Names: Iqbal, Adam S., 1983 author.

Title: Volatility : practical options theory / by Adam S. Iqbal.

Description: Hoboken, New Jersey : John Wiley & Sons, Inc., [2018] | Series: Wiley finance | Includes bibliographical references and index. |

Identifiers: LCCN 2018012654 (print) | LCCN 2018013434 (ebook) | ISBN 9781119501671 (pdf) | ISBN 9781119501688 (epub) | ISBN 9781119501619 (cloth)

Subjects: LCSH: Options (Finance) | SecuritiesPricesMathematical models.

Classification: LCC HG6024.A3 (ebook) | LCC HG6024.A3 I72 2018 (print) | DDC 332.64/5301dc23

LC record available at https://lccn.loc.gov/2018012654

Cover Design: Wiley

Cover Image: enjoynz / iStockphoto

To Mum, Dad, my wife, Gosia, and my beautiful oneyearold daughter, Maria, without whom this book would have been finished up to one year earlier.

This book studies options, the financial contracts that provide exposure to volatility. It has one main objective.

While there already exist several excellent references on the mathematical theory underlying options (Shreve, 2000, Duffie, 2001, and Bjork, 2009) are examples among a list too long to complete here), there is a relative absence of texts that attempt to explain how to bring the many theoretical ideas into practice. The main objective in this book is to provide an intuitive, as well as technical, understanding of both the basic and advanced ideas in options theory, with the aim of encouraging translational work from theory into practical application by market makers, portfolio managers, investment managers, risk managers, traders, and other market practitioners.

I show the reader that several of the most important concepts in options theory such as implied volatility, delta hedging, time value, and many of the socalled option Greeks can be understood by appealing to intuitive economic arguments alone, without the need to build a formal mathematical model. Once this knowledge is in place, I go on to explain the seminal BlackScholesMerton mathematical model. The reader will understand how the modelfree approach and mathematical models are related to each other, their underlying theoretical assumptions, and their implications to a level that facilitates their practical implementation.

The approach taken in this book may prove valuable to options traders and other practitioners tasked with making pricing or risk management decisions in an environment where time constraints mean that simplicity and intuition are of greater value than mathematical formalism. This approach may also prove useful to academics interested in the translational process of theoretical options pricing into practical application, and in the feedback loop between academia and practice.

The majority of the concepts in this text are applicable to options on equities, bonds, and commodities. However, this book provides indepth insight into the theoretical and practical function of the FX options overthecounter (OTC) market. Given the liquidity in FX spot (and forwards) markets and the lower number of trading constraints (such as short selling; selling EURUSD is the same as buying USDEUR), FX markets arguably provide one of the better opportunities to implement the theoretical ideas presented here.

The target audience for this book includes, but is not limited to, industry practitioners, finance and economics advanced undergraduate and graduate students, MBA students, and academics interested in translational finance. I presume some exposure to undergraduate level probability, statistics, and calculus. However, this should not deter readers with less exposure to these topics for at least two reasons. First, the presentation is consciously informal with the aim of exposing ideas in their simplest form before going back and understanding their foundations. Second, I provide several mathematical appendices to assist such readers and to keep this book selfcontained with respect to the most important concepts. Although at times it may not seem to be the case, the challenges in successful options trading are conceptual rather than mathematical.