Friday, September 25, 2009

Natenberg, Basic Option Volatility Strategies

Sheldon Natenberg is best known for his 1994 classic Option Volatility and Pricing. In an effort to bring the concept of option volatility to the mathematically challenged, Natenberg wrote Option Volatility Trading Strategies in 2007. This book has now been updated with bonus online content under the title Basic Option Volatility Strategies: Understanding Popular Pricing Models (Marketplace Books, 2009).

Curiously, in some ways I found this book more difficult to grasp than his first book. On the surface, it’s very easy sailing; you can zip through it in no time. But you’re left not quite knowing what you’ve learned. Admittedly, I didn’t listen to the hour and a half video that accompanies this book, nor did I take the tests and check the answers online.

Volatility trading, as Natenberg describes it, is a virtually impossible strategy for the retail trader; it’s straight out of the market maker’s playbook. It is, in a nutshell, “a multi-step option hedging strategy that begins by identifying options that are mispriced in the marketplace, then buying those that are under-priced and/or selling those that are overpriced. As a second step, you then offset your initial option position by taking an opposing market position—a delta-neutral position—in the underlying security. . . . Finally, over the life of your volatility trade, you would periodically buy (or sell) shares of the underlying security as needed to keep the entire position delta-neutral (a process known as ‘dynamic hedging’). The goal of volatility trading is thus to create a risk-free position that will capture the disparity between an option’s inaccurate market price and its true value.” (p. 147)

But just because volatility trading requires a larger inventory than most retail options traders will ever have need to manage and ideally a commission-free trading environment (and the reader gleaning some basic ideas from this book should never even contemplate it) doesn’t detract from the critical importance of the notions of volatility. Natenberg identifies four kinds of volatility. First, there’s future volatility—the volatility of the underlying contract over some period, usually the period between the present and the applicable options expiration. Second, there’s historical volatility—the fluctuation of prices in the underlying in the past. Third, there’s forecast volatility, that is, the projections that volatility forecasting services provide about the volatilities of the underlying contracts. And finally, and the only kind of volatility that applies directly to options, is implied volatility—the marketplace’s own forecast of the future volatility of options.

“All option decisions begin by comparing implied volatility to the future volatility. Why? Because we equate implied volatility with the price of the option and equate the future volatility with the value of the option. That’s an absolute: it doesn’t matter what you’re trading, whether it’s options or anything else. You are always trying to compare price and value. If something has a high price and a low value, I want to be a seller. If something has a high value and a low price, I want to be a buyer.” (pp. 79-80) It’s easy to dismiss this insight as just another way of saying “buy low and sell high or sell high and buy back low” but, especially when looking at options trades, it’s critical to have some method of predicting the future volatility of the underlying contract, whether it be systematic or discretionary. Then and only then can the trader start to figure out what kind of an options trade to put on.

2 comments:

  1. Thank you for your review of our book! I appreciate you taking the time, and I hope you have a chance to watch the video and take the online tests; these components are a major part of the education found in our "course book" series. If you have any other questions or comments, feel free to contact me Jody Costa, executive editor at Marketplace Books. Visit www.marketplacebooks.com Thanks again, Brenda! Best wishes to you and keep up the good work!!

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  2. I appreciate your post, thanks for sharing the post, i would like to hear more about this in future

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