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Book Review: Volatility Trading

This is a book about trading volatility professionally. The target audience is those who already have some familiarity with options theory and are ready to use math in their market analysis. One does not need to be a professional options trader but the book instructs a professional attitude toward trading.

It accomplishes two goals very well. First, it delivers a set of knowledge about volatility markets. Second, it delivers the message that trading is hard and demands deliberate focus. So while the actual material is on the volatility markets, the theme of the book is that one should use all of tools at our disposal, use a systematic methodology and target continuous improvement. In short, if you wish to learn about volatility trading or, in general, how to approach trading of any sort as a business, you will benefit greatly from Volatility Trading. This is not idle talk. I ran an options trading desk and purchased a copy for each person working for me.

Despite having a PhD (yes, despite) and including the relevant math, Sinclair is clear and overwhelmingly practical. Even for those that already trade volatility products, as I do, there is much value in the material. He does much work for us, including:

1)      Reading a vast amount of academic and industry research, as well as conducting his own; then highlighting the most valuable nuggets.

2)      He puts into clear prose and practical context those most valuable results. For example, the explanation of why leveraged ETF’s erode in value but are not “destined to go to zero” was illustrated nicely with text that complemented the math. Math is necessary and adds to the explanation.

3)      He puts the theory into the context of practical reality. Although this is most obvious when he discusses the shortcomings but utility of the Black-Scholes framework, it comes through elsewhere such as under what circumstances higher efficiency estimators fail back into the daily close-close estimator.

That said, there is subject matter relevant to volatility trading that is not covered but still important to volatility trading. For example, volatility options (VIX options) or dealing with portfolios of options. The subjects covered are, for the most part, covered well – the section on behavioral finance is, understandably, given only a quick run through. Even in this section, the practical nature of Sinclair’s outlook shows through as he discusses that we should mind our own foibles for mistakes but also look to those same foibles for sources of potential edge.

From the perspective of trading as a professional, Sinclair bangs the drum on:

1)      Quantify what you can.

2)      Remember #1, but using non-quantifiable information is valuable and, often, necessary.

3)      Understanding that trading, particularly options trading that is so path dependent, is about playing the probabilities. Keep the long run in mind.

4)      Trading requires having an edge; to best exploit it, understand it and the tools you use.

5)      Emphasize the practical, particularly developing a process.

I cannot provide a review of the web site as I have not yet used it.

I will conclude with Sinclair’s own words: “Successful trading is about developing a consistent process.” Knowledge is essential but insufficient. I think that is what Euan Sinclair would hope the reader came away with and kept. Everything else can be researched – and much of it can be found in “Volatility Trading.” I find it very valuable and highly recommend it.

If you enter Amazon through my site (the image above), I will get a small commission. I am experimenting with this as a source of revenue for my blog. Hopefully reviewing the book (and my other posts) added some value. If so, great. Incidentally, the commission is already built into Amazon prices and the price stays the same whether you enter from my site or not.

Another Zoetis Article

I followed up my first article on the Zoetis deal with this one. I’m learning on the job. As I am not the most experienced at looking at deals & spinoffs, would love to hear from those that have insight.

Zoetis Article on Seeking Alpha

I recently completed a piece on why Zoetis looks like an attractive short candidate. It is a spinoff from Pfizer.

You can read the article on Seeking Alpha.

Apple Dividend Play Follow-Up

Anyone who has never made a mistake has never tried anything new.   

Albert Einstein


On April 15, I wrote an instablog post on SeekingAlpha. It explained how the forward price of a stock is impacted by its dividend and how to structure an options trade that should benefit from a higher dividend. The article went through scenarios for purchasing a conversion on Apple (AAPL) and the cash flows. As it turns out, Apple did raise its dividend. I’m going to go through the market results so far.

First, let’s review the trade and what happened. I suggested looking at Jan 2014 conversions. Mid-market was $7.03 and I wrote that it would likely cost $7.50 to get into the trade. At the time of the article, AAPL’s dividend was $2.65 per quarter. On their earnings announcement, Apple raised its dividend to $3.05 per quarter. It turned out that was below my “conservative” estimate of $3.60 based on matching the yield of other, similar tech giants. Instead, Apple’s management chose to enhance shareholder return primarily through buybacks.

It is now May 2nd. As I write this, AAPL is $447. It’s next ex-dividend date is May 9. We can reasonably expect two additional dividend payments of $3.05 prior to the Jan 18th 2014 option expiration. Likely dates are August 8th and November 7th (I’m predicting Thursdays). I’ll continue to use a discount rate of 0.5% as I did in the prior post. Had AAPL still had a $2.65 dividend (to be clear, it doesn’t), then the forward would be:

F = $447e(.005)(.715) – $2.65e(.005)(.696) – $2.65e(.005)(.447) – $2.65(.005)(.197) = $440.63

Since AAPL actually did change its dividend, its forward will now be:

F = $447e(.005)(.715) – $3.05e(.005)(.696) – $3.05e (.005)(.447) – $3.05e (.005)(.197) =$439.43

That is a difference of $1.20, which, due to near zero interest rates, is the same as the difference in three dividend payments of 40c each. So far, so good. One expects the conversion to move the same amount, too.

Recall that we valued the forward at $6.17, but that the mid-market price was at the time $7.03. The market appeared to be pricing a move in the dividend. Given the scenarios that I had envisioned, it appeared to be a worthwhile risk to pay $7.50 based on the scenarios in the Expectations section of the post. The current Jan 2014 at-the-money (ATM – meaning those options closest to the forward price of AAPL) conversion is $6.62-$7.56, with a mid-market of $7.09. Putting things together, our forward calculations moved from $6.17 to $7.57 ($447 – $439.43).  Note that is a difference of $1.40, not $1.20. Those extra 20c are the interest costs that already were paid for holding the trade since April 15th.

Where is the difference between the forward and the current conversion price from? From the early exercise provision of American style options. This is where the quote from Einstein comes in. As it turns out, it is the quote for the chapter “Options on Stocks that Pay Discrete Dividends” from Espen Haug’s excellent The Complete Guide to Option Pricing Formulas book. I’ve no idea what motivated him to put that quote with that chapter, but it fits well with my situation. Perhaps he, too, made a mistake in a dividend exercise situation. Or perhaps he was referring to the Roll-Geske-Whaley model which had been used to price options with dividends but turns out to be incorrect. At any rate, my problem is that in addition to putting this trade on with options expiring Jan 2014, I also put it on with options expiring May 17, 2013 (in 2 weeks). It will make a nice illustration of dividend driven early exercise risks.

Starting with the 2014 conversion, if one gets an appropriate option model that can properly handle discrete dividends (hence my dive back into Haug’s book), the theoretical price of the Jan 2014 440 conversion when AAPL is $447 is $7.31; note for European style options it is $7.58 – matching our forward. The early exercise makes a difference, albeit only a 27c difference. Why should early exercise matter? Because should Apple rebound, the extrinsic value of the call can become less than the dividend to be earned. Another way of looking at this is to compare the deep call with its analogue put. If the extrinsic value for the corresponding put is less than the dividend, one exercises the call to own the stock just prior to the ex-dividend date. For options expiring in 2014 with 3 dividends and a lot of extrinsic premium, it doesn’t matter much.

But for the May 17, 2013 options, it matters a lot. Consider that I purchased the May 400 conversion for $2. Now that AAPL is $447, those May 400 puts are not worth much. Right now they are trading around 74c. 74c is considerably lower than the dividend of $3.05. Why do I care about the puts?  We are talking about the calls. A position of long 1 call and short 100 shares is (most of the time) equivalent to one put. This is called a synthetic and it requires explaining on its own, but stick with me. If a trader has a position of long call and short stock, it pays to exercise the calls to collect the dividend. The trader can replicate the same risk profile by purchasing the puts for 74c in the open market. Think about that for a moment. He exercises the call which is equivalent to selling it, receives shares that pay him/her $3.05 and then creates the same risk position by buying puts for $0.74.

That was my mistake. I was technically short AAPL and didn’t realize it. I had paid $2 for the conversion thinking I would collect my dividend. But since AAPL rallied 10% those puts are not worth much at all. I’m probably going to get my shares called away from me so that some other guy will get the $3.05. D’oh.