Option Trading is a comprehensive guide to this discipline covering everything from historical background, contract types, and market structure to volatility measurement, forecasting, and hedging techniques. This comprehensive guide presents the detail and practical information that professional option traders need, whether they’re using options to hedge, manage money, arbitrage, or engage in structured finance deals. It contains information essential to anyone in this field, including option pricing and price forecasting, the Greeks, implied volatility, volatility measurement and forecasting, and specific option strategies.
This book is roughly divided into three parts. First we will introduce options, both historically and conceptually. Next we use the no-arbitrage principle to introduce option pricing. We examine both static arbitrage relationships and the dynamic hedging approach. The last, and largest, part of the book is about how to actually trade options.
In Chapter 1 we discuss the history of options and other financial derivatives. I think these stories are interesting, but even if they were not interesting, they would be important. Chapter 2 introduces options and option markets. While this is undoubtedly boring material, it is probably the most important chapter in the book. Chapter 3 is the first chapter in the pricing section of the book. We introduce the concept of no arbitrage and use it to derive relationships between call and puts and options of different strikes and maturities.
In Chapter 4 we work through the two most important option pricing models: the binomial tree and the Black-Scholes-Merton (BSM) model. Chapter 5 examines the solution to the BSM model and introduces the famous greeks, the sensitivities of the option price to various parameters and variables. Chapter 6 looks at the various strategies that can be constructed from simple calls and puts. Many books do this, but most do so from the perspective of a customer who is trying to construct a directional bet with certain risk characteristics.
Chapter 7 shows how to measure and forecast volatility. Chapter 8 is somewhat complementary. Here we consider the nature and behavior of implied volatility: the volatility that the option market is using at any point. The interplay between implied volatility and realized volatility is central to the theory and practice of option trading. In Chapter 9 we introduce the concept of expected value, the general idea of hedging and the idea of trade sizing: looking at a trade as a part of a continuing business plan rather than a single unrepeated bet.
Chapter 10 discusses the basic ideas and strategies of market making. Not all option traders will be market makers, but all traders can benefit from understanding their behavior. In Chapter 11 we examine volatility trading, in particular, how to hedge and what to expect when we do. Volatility trading is a viable stand-alone strategy, but it also needs to be understood by any trader using options.
Chapter 12. Nothing about expiration is really fundamentally different from any other time, but everything that happens is far more extreme. Everything a trader does, and everything in this book, is about risk management. All trades must be evaluated by both their return and their risk. We spend a lot of time estimating probabilities of events before we do a trade. But we also need to make sure that in no state of the world, no matter how unlikely, can the trade cause us to go broke. This type of analysis is covered in Chapter 13.
- Introduction to Options
- Arbitrage Bounds for Option Prices
- Pricing Models
- The Solution of the Black-Scholes-Merton (BSM) Equation
- Option Strategies
- Volatility Estimation
- Implied Volatility
- General Principles of Trading and Hedging
- Market Making Techniques
- Volatility Trading
- Expiration Trading
- Risk Management