Euan Sinclair 
Volatility Trading 

In Volatility Trading, Sinclair offers you a quantitative
model for measuring volatility in order to gain an edge in your
everyday option trading endeavors. With an accessible,
straightforward approach. He guides traders through the basics of
option pricing, volatility measurement, hedging, money management,
and trade evaluation. In addition, Sinclair explains the
often-overlooked psychological aspects of trading, revealing both
how behavioral psychology can create market conditions traders can
take advantage of-and how it can lead them astray. Psychological
biases, he asserts, are probably the drivers behind most sources of
edge available to a volatility trader.

Your goal, Sinclair explains, must be clearly defined and easily
expressed-if you cannot explain it in one sentence, you probably
aren’t completely clear about what it is. The same applies to your
statistical edge. If you do not know exactly what your edge is, you
shouldn’t trade. He shows how, in addition to the numerical
evaluation of a potential trade, you should be able to identify and
evaluate the reason why implied volatility is priced where it is,
that is, why an edge exists. This means it is also necessary to be
on top of recent news stories, sector trends, and behavioral
psychology. Finally, Sinclair underscores why trades need to be
sized correctly, which means that each trade is evaluated according
to its projected return and risk in the overall context of your
goals.

As the author concludes, while we also need to pay attention to
seemingly mundane things like having good execution software, a
comfortable office, and getting enough sleep, it is knowledge that
is the ultimate source of edge. So, all else being equal, the
trader with the greater knowledge will be the more successful. This
book, and its companion CD-ROM, will provide that knowledge. The
CD-ROM includes spreadsheets designed to help you forecast
volatility and evaluate trades together with simulation engines.

Table of Content

Introduction 1

The Trading Process 3

Chapter 1 Option Pricing 7

The Black-Scholes-Merton Model 7

Summary 14

Chapter 2 Volatility Measurement and Forecasting 15

Defining and Measuring Volatility 15

Definition of Volatility 16

Alternative Volatility Estimators 22

Close-to-Close Estimator 26

Parkinson Estimator 26

Garman-Klass Estimator 27

Rogers-Satchell Estimator 27

Yang-Zhang Estimator 27

Using Higher-Frequency Data 27

Forecasting Volatility 31

Maximum Likelihood Estimation 36

Forecasting the Volatility Distribution 39

Summary 43

Chapter 3 Implied Volatility Dynamics 45

Volatility Level Dynamics 48

Informal Definition 50

More Formal Definition 50

A Traders’ Definition 50

Smile Dynamics 54

Summary 62

Chapter 4 Hedging 63

Ad Hoc Hedging Methods 65

Hedging at Regular Intervals 65

Hedging to a Delta Band 65

Hedging Based on Underlying Price Changes 65

Utility-Based Methods 66

The Asymptotic Solution of Whalley and Wilmott 71

The Double Asymptotic Method of Zakamouline 74

Estimation of Transaction Costs 78

Aggregation of Options on Different Underlyings 83

Summary 85

Chapter 5 Hedged Option Positions 87

Discrete Hedging and Path Dependency 87

Volatility Dependency 93

Summary 99

Chapter 6 Money Management 101

Ad Hoc Schemes 101

The Kelly Criterion 103

Alternatives to the Kelly Criterion 113

Trade Sizing in a Continuously Changing Setting 118

A Simple Approximation 124

Summary 126

Chapter 7 Trade Evaluation 127

General Planning Procedures 128

Risk-Adjusted Performance Measures 134

The Sharpe Ratio 135

Alternatives to the Sharpe Ratio 137

Setting Goals 140

Persistence of Performance 142

Relative Persistence 143

Absolute Persistence 144

Summary 147

Chapter 8 Psychology 149

Self-Attribution Bias 151

Overconfidence 152

The Availability Heuristic 155

Short-Term Thinking 156

Loss Aversion 157

Conservatism and Representativeness 158

Confirmation Bias 160

Hindsight Bias 161

Anchoring and Adjustment 162

Summary 162

Chapter 9 Life Cycle of a Trade 165

Pretrade Analysis 165

June 25, 2007 165

June 26, 2007 169

June 27, 2007 169

June 28, 2007 170

June 29, 2007 170

July 2, 2007 170

July 3, 2007 170

Post-Trade Analysis 171

Summary 173

Chapter 10 Conclusion 175

Execution Ability 176

Concentration 177

Product Selection 177

Appendix A: Model-Free Implied Variance and Volatility 179

The VIX Index 180

Appendix B: Spreadsheet Instructions 183

GARCH 183

Volatility Cones and Skew and Kurtosis Cones 184

Daily Option Hedging Simulation 184

Trade Evaluation 185

Trading Goals 185

Corrado-Su Skew Curve 185

Mean Reversion Simulator 186

Resources 187

Essential Books 187

Thought-Provoking Books 189

Useful Web Sites 190

References 193

About the CD-ROM 201

Index 203

About the author

EUAN SINCLAIR is an option trader with over ten years of experience trading options professionally. He specializes in the design and implementation of quantitative trading strategies. Sinclair is currently a proprietary option trader for Bluefin Trading, where he trades based on quantitative models of his own design. He holds a Ph D in theoretical physics from the University of Bristol.