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 PhD in theoretical physics from the University of Bristol.

In Volatility Trading, Sinclair offers you a quantitativemodel for measuring volatility in order to gain an edge in youreveryday option trading endeavors. With an accessible,straightforward approach. He guides traders through the basics ofoption pricing, volatility measurement, hedging, money management,and trade evaluation. In addition, Sinclair explains theoften-overlooked psychological aspects of trading, revealing bothhow behavioral psychology can create market conditions traders cantake advantage of-and how it can lead them astray. Psychologicalbiases, he asserts, are probably the drivers behind most sources ofedge available to a volatility trader.
Your goal, Sinclair explains, must be clearly defined and easilyexpressed-if you cannot explain it in one sentence, you probablyaren't completely clear about what it is. The same applies to yourstatistical edge. If you do not know exactly what your edge is, youshouldn't trade. He shows how, in addition to the numericalevaluation of a potential trade, you should be able to identify andevaluate the reason why implied volatility is priced where it is,that is, why an edge exists. This means it is also necessary to beon top of recent news stories, sector trends, and behavioralpsychology. Finally, Sinclair underscores why trades need to besized correctly, which means that each trade is evaluated accordingto its projected return and risk in the overall context of yourgoals.
As the author concludes, while we also need to pay attention toseemingly mundane things like having good execution software, acomfortable office, and getting enough sleep, it is knowledge thatis the ultimate source of edge. So, all else being equal, thetrader with the greater knowledge will be the more successful. Thisbook, and its companion CD-ROM, will provide that knowledge. TheCD-ROM includes spreadsheets designed to help you forecastvolatility and evaluate trades together with simulation engines.

Introduction 1The Trading Process 3Chapter 1 Option Pricing 7The Black-Scholes-Merton Model 7Summary 14Chapter 2 Volatility Measurement and Forecasting 15Defining and Measuring Volatility 15Definition of Volatility 16Alternative Volatility Estimators 22Close-to-Close Estimator 26Parkinson Estimator 26Garman-Klass Estimator 27Rogers-Satchell Estimator 27Yang-Zhang Estimator 27Using Higher-Frequency Data 27Forecasting Volatility 31Maximum Likelihood Estimation 36Forecasting the Volatility Distribution 39Summary 43Chapter 3 Implied Volatility Dynamics 45Volatility Level Dynamics 48Informal Definition 50More Formal Definition 50A Traders' Definition 50Smile Dynamics 54Summary 62Chapter 4 Hedging 63Ad Hoc Hedging Methods 65Hedging at Regular Intervals 65Hedging to a Delta Band 65Hedging Based on Underlying Price Changes 65Utility-Based Methods 66The Asymptotic Solution of Whalley and Wilmott 71The Double Asymptotic Method of Zakamouline 74Estimation of Transaction Costs 78Aggregation of Options on Different Underlyings 83Summary 85Chapter 5 Hedged Option Positions 87Discrete Hedging and Path Dependency 87Volatility Dependency 93Summary 99Chapter 6 Money Management 101Ad Hoc Schemes 101The Kelly Criterion 103Alternatives to the Kelly Criterion 113Trade Sizing in a Continuously Changing Setting 118A Simple Approximation 124Summary 126Chapter 7 Trade Evaluation 127General Planning Procedures 128Risk-Adjusted Performance Measures 134The Sharpe Ratio 135Alternatives to the Sharpe Ratio 137Setting Goals 140Persistence of Performance 142Relative Persistence 143Absolute Persistence 144Summary 147Chapter 8 Psychology 149Self-Attribution Bias 151Overconfidence 152The Availability Heuristic 155Short-Term Thinking 156Loss Aversion 157Conservatism and Representativeness 158Confirmation Bias 160Hindsight Bias 161Anchoring and Adjustment 162Summary 162Chapter 9 Life Cycle of a Trade 165Pretrade Analysis 165June 25, 2007 165June 26, 2007 169June 27, 2007 169June 28, 2007 170June 29, 2007 170July 2, 2007 170July 3, 2007 170Post-Trade Analysis 171Summary 173Chapter 10 Conclusion 175Execution Ability 176Concentration 177Product Selection 177Appendix A: Model-Free Implied Variance and Volatility 179The VIX Index 180Appendix B: Spreadsheet Instructions 183GARCH 183Volatility Cones and Skew and Kurtosis Cones 184Daily Option Hedging Simulation 184Trade Evaluation 185Trading Goals 185Corrado-Su Skew Curve 185Mean Reversion Simulator 186Resources 187Essential Books 187Thought-Provoking Books 189Useful Web Sites 190References 193About the CD-ROM 201Index 203