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Option Trading

Euan Sinclair
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Overview
Session One: Introduction to options, pricing and greeks.
Session Two: General trading principles. Volatility
measurement and forecasting.
Session Three: The variance premium. Hedging. Expiration
trading.
Session Four: Risk management. Some examples of trades.
Trade evaluation.

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Option Trading
Session Four: Trade Evaluation and a
Trade

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Session Four Overview

• Expiration issues.
• We are going to look at the life of a trade.
• Pre-trade expectations.
• Find mispriced vols.
• Execute and hedge.
• Evaluate.

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Expiration Trading
• Very close (hours) to expiration, options lose most
optionality.
• If ITM behave as underlying.
• If OTM behave as worthless.
• The tricky part is what happens at the strike.
• Note that pricing models don’t “break” at expiration. They
are still a helpful guide.

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Expiration Trading: Pinning

• The underlying will settle near a strike much more than
randomness would imply.
• This is due to market makers hedging long gamma, as a
result shorts don’t need to hedge.
• Sell ATM options close to expiration, ideally those with
high open interest.

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Expiration Trading: Pin Risk

• If the market settles at a strike, it can be very difficult to
predict which options will be exercised.
• Be aware that slightly OTM options can be exercised.
• Sometimes done to squeeze the underlying or to avoid
slippage in liquidating a large underlying position.

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Expiration Trading: Cash Settlement

• Cash settled options will be hedged with futures.
• At expiration, the futures position will still be there.
• Need to allow for unwinding.

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Expiration Trading: Greeks

• Greeks are still correct, but may be misleading.
• For example, a one-hour straddle will often have theta 20
times higher than its value.
• Also, gamma is actually infinite right at the strike.
• Sometimes useful to set implied volatility to zero to avoid
possible confusion.

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Volatility Trading
• Recall from Session One that when we derived BSM we
actually priced the replication value of the option.
• This depends on realized volatility.
• But option price in the market depends on implied
volatility.
• So if realized volatility is not equal to implied volatility we
can trade the option, replicate it in the underlying and
profit.

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Volatility Trading
• Theoretical profit:

𝑃𝐿 = 𝑉𝑒𝑔𝑎 𝜎𝐼 − 𝜎𝑅

• But only on average…

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Cutting to the End – What is a Good Trade?

• A good trade is one that we would repeat no matter the
result.
• Requires positive expectation and an acceptable level of
risk.
• EV is risk-neutral but “acceptable risk” varies between
traders and firms.
• Multi-dimensionality and path dependency of options
mean results don’t tell whole story in any single case.

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A Good Trade Example

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Pre-Trade Planning
• If you haven’t tested an idea you are just guessing.
• Back-testing.
• Academic results.
• Seeing another trader’s results.
• If you don’t know what to expect you can’t know if a trade
is working.

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Evaluating a Single Trade

• Can’t really be done.
• Luck dominates any one idea or trade.
• Need to keep records of all trades of a certain type.
• “Keep a trading journal” is most said and least followed
trading advice.
• If you don’t keep records you are utterly worthless: if you
can’t prove where your edge is it probably not existent.

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How do you feel?

• Probably bad.
• A winner makes you wish you had traded bigger.
• A loser makes you wish you hadn’t traded.
• Regret is the dominant emotion of trading, not greed or
fear.
• Deal with it or get a therapist (Seriously. This is actually an
area where sensible psychology can help.)

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Evaluating a Strategy
• No one thing is enough.
• Minimum: trade frequency, average PL, win %, worst loss
in a given period, worst draw down, Sharpe.
• If sample is big enough the entire distribution might be
informative.

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The Sharpe Ratio

• William Sharpe: Nobel prize winner in 1990.
• The Sharpe ratio has weaknesses.
• BUT if you think a Nobel winner is dumber and hasn’t
thought of these, you may have missed something.
• Contrarian: someone who doubts everything except the
outstanding power of his intellect.

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The Sharpe Ratio

• All risk ratios are similar.
• Numerator is something good like return or risk adjusted
return.
• Denominator is something bad like volatility, downside
volatility, mean deviation, draw down, averaged draw
down.
• Sharpe is excess return divided by volatility.

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Sharpe Ratio Weaknesses

• Volatility penalizes large up moves as heavily as down moves.
• Ignores higher order moments. E.g positive skew should be
rewarded but isn’t.

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Sharpe Ratio Weaknesses

• Fairly large sampling error (SD is usually the same magnitude as
result).
• All of these are known and aren’t really a problem. Don’t worry
too much…

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Performance Persistence
• Are results changing over time?
• A good way to measure skill is repeatability of performance, and
separating skill from luck is the central problem in evaluating
strategies and traders.
• Can just use a t test to compare means of different periods (simple
but weak).
• Kolmogorov-Smirnov test (a bit better).

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K-S Test for Comparing Samples

• Get maximal difference, D.
• Samples are different (95%)
level if

𝑛+𝑚
𝐷 > 1.36 ×
𝑛𝑚

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Example of K-S Test

• Results for 20 trades. Results

• Mean: 0.19 2.5

• SD 1.22 1.5

frequency
• EV 1.02 1

0.5

Percentage Gain

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Example of K-S Test

• What is baseline case for happiness?
• Want to beat zero mean and 80% volatility.
• Obviously non-normal results, so I choose a shifted lognormal
(100 trades). Results
2.5

2
frequency

1.5

0.5

0
-0.9
-0.7
-0.5
-0.3
-0.1
0.1
0.3
0.5
0.7
0.9
1.1
1.3
1.5
1.7
1.9
2.1
2.3
2.5
2.7
2.9
3.1
3.3
3.5
3.7
3.9
Percentage Gain

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Example of K-S Test

• Apply K-S to see if I can say I beat my benchmark.

Results
2.5

1.5
frequency

0.5

0
-0.9 -0.7 -0.5 -0.3 -0.1 0.1 0.3 0.5 0.7 0.9 1.1 1.3 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 3.3 3.5 3.7 3.9
Percentage Gain

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Example of K-S Test

• Construct cumulative distributions and see D=0.2 .

Cumulative Distributions
1.2

0.8

0.6

0.4

0.2

0
-0.1
-0.9
-0.7
-0.5
-0.3

0.1
0.3
0.5
0.7
0.9
1.1
1.3
1.5
1.7
1.9
2.1
2.3
2.5
2.7
2.9
3.1
3.3
3.5
3.7
3.9
• Not significant at 10% level (would need 150 trades).

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Meta Analysis
• Work on strengths and avoid weaknesses. You don’t get paid
to be an all rounder. Trading is basketball, not golf.
• “Play” with new ideas in small size. You will go off script
anyway and this way might lead to something.
• When things look deteriorate, look for concrete reasons.

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How Does this Help?

• Knowing numerical results won’t really lead to obvious
improvements.
• But knowing you are doing as well as your thought would be is
very helpful.
• Knowing non-quantitative results can help. E.g. trading on Fed
days.
• Possible that a trade is good but not if you do it.

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An Actual Trade
• We will start with a situational trade (easier to find).
• Specifically, the index variance premium.
• We will be selling SPY options.

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There is an Edge… Now Find a Hedge

• It is OK to have exposure to a risk factor (in this case equity
volatility) but we can’t have exposure to an overall
catastrophe.
• We could (maybe should) buy some downside puts, but this
still leaves us short net options and exposed to the
catastrophic event.

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Vol vs Vol of Vol

Dvvix
0.7

0.6

0.5

0.4

0.3
Dvix

0.2

0.1

0
-0.4 -0.2 0 0.2 0.4 0.6 0.8

-0.1

-0.2

-0.3

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VIX vs VVIX
• Correlation of changes: 78%
• Beta: 1.02
• So we will buy some sort of volatility options as our hedge.
• Is there edge here?
• Yes. See “Trading the VIX Futures Roll and Volatility Premiums
with VIX Options”

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UVXY
• Double leveraged, constant maturity VIX future ETN.
• Leverage creates decay in most situations.
• E.g. Reference: 100->110->99.
• Leveraged 100->120->96
• “Volatility drag”.
• Actual situation more complicated…

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UVXY

UVXY
45000000

40000000

35000000

30000000

25000000

20000000

15000000

10000000

5000000

0
04-10-2011 04-10-2012 04-10-2013 04-10-2014 04-10-2015 04-10-2016 04-10-2017

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UVXY
• Current contango gives expected contango decay of $0.06
(0.4%).
• Current leverage effect gives further decay of about $0.12
(0.8%).
• So we expect a drift of $0.18 (1.2%) per day.
• Over the last year the decay has been 0.9%.

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A Real Trade
• Sell 100 March, 2018 SPY straddle for 12.34 on December
1st, 2017 (vol of 8.1%).
• Buy March UVXY straddle for 8.89 on December 1st, 2017
(vol of 111%).
• We need enough UVXY to hedge us in volatility space. So
we buy 90 UVXY straddles.

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Recall Hedging: Drift VS No Drift

Position Market Volatility Bias for

Hedging

Short Gamma Trending Low

Short Gamma Range Bound High

Long Gamma Trending High

Long Gamma Range Bound Low

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Our Choice
• Don’t need to worry about MTM so I’ll accept day to day
risk and higher variance by hedging at my forecast
volatility.
• I’ll also bias my UVXY volatility forecast high because I will
be long gamma in that trending market.

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Forecasting Volatility
• “Trader GARCH” forecasts UVXY volatility to be 0.98, SPY
volatility to be 0.069 (each with an error of about 5%)
• More importantly, we are long UVXY options and expect it
to trend. So we bias our estimate high. I will use a
volatility of 1.10.
• We are short SPY options and don’t expect a trend, so
also bias this high. I use 0.08.

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Choosing a Hedging Band

1
2 3
𝜕𝑉 3 𝑒𝑥𝑝 −𝑟 𝑇 − 𝑡 𝜆𝑆Γ
∆= ±
𝜕𝑆 2 𝜅

• Lambda is proportional transaction cost. For SPY this is

about 0.00002
• Kappa is risk aversion.
• Choose gamma to get a band of 0.1 (let ATM straddle get
to 40 delta). This is gamma of 1.25.
• Means we let UVXY slop by 30 deltas.

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Choosing a Hedging Band

• On day one we would let SPY move about a dollar (263 to
262 or 264) and UVXY about a dollars (14 to 12.5 or 15.5).
• Why allow so much slop?
• First, I just feel like it, and preferences are just that.
• Second, I want to hedge by rolling options to maintain
ATM volatility exposure, and this can be expensive in
UVXY.

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Expected PL
• < PL > = 𝑉𝑒𝑔𝑎(σ𝑖 − σ𝑟 )
• Spy = $18,600.
• UVXY = -$8,900.
• Total = $9,700

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Variability of PL
• Using MC we find that even if we are correct in our
estimates:
• SPY PL has an SD of $10,000
• UVXY PL has an SD of $4,000

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SPY Results
• Total loss of $107,000.

SPY PL
40000

20000

0
01-12-2017 01-01-2018 01-02-2018 01-03-2018
-20000

-40000

-60000

-80000

-100000

-120000

-140000

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UVXY Results
• Total gain of $41,000.

UVXY PL
90000
80000
70000
60000
50000
40000
30000
20000
10000
0
01-12-2017
-10000 01-01-2018 01-02-2018 01-03-2018

-20000

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Total Results
• Total loss of $66,000.

Total PL
40000

20000

0
01-12-2017 01-01-2018 01-02-2018 01-03-2018
-20000

-40000

-60000

-80000

-100000

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Postmortem
• Realized SPY volatility was 16.8 (sold 8.1 and predicted
6.9).
• Could expect a loss of $135,000, with SD of 70,000.
• So SPY PL was in line.
• Realized UVXY volatility was 92 (bought 111 and predicted
98).
• Could expect a loss of $13,000 with SD of 8,000.
• So we were actually lucky with UVXY.

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Other Possible Factors

• UVXY didn’t trend.
• So hedge bias was wrong. We could have done
better by scalping more often.
UVXY
35

30

25

20

15

10

0
01-12-2017 01-01-2018 01-02-2018

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Other Possible Factors

• UVXY was re-specified, but this was on 27th of
February. Far too late to be an issue.
• The UVXY volatility was clustered in a week, while
SPY volatility persisted.

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Conclusion
• Basically, “we were what our results said we were” (attrib.
Bill Parcells).
• Wrong.

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Course Summary
Session One: Introduction to options, pricing and greeks.
Session Two: General trading principles. Volatility measurement
and forecasting.
Session Three: The variance premium. Hedging. Expiration
trading.
Session Four: Risk management. Some examples of trades.
Trade evaluation.

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