Wednesday, September 15, 2010

Sinclair, Option Trading

Euan Sinclair set an unattainable goal for himself: he wanted Option Trading: Pricing and Volatility Strategies and Techniques (Wiley, 2010) to be “the only book an intelligent, diligent person would need in order to go from knowing nothing about options to being able to trade professionally at a legitimate trading operation.” (p. xii) Nonetheless this book lays a solid foundation. After a history and introduction to options, the remaining eleven chapter titles indicate the depth and seriousness of Sinclair’s book: arbitrage bounds for option prices, pricing models, the solution of the Black-Scholes-Merton equation, option strategies, volatility estimation, implied volatility, general principles of trading and hedging, market making techniques, volatility trading, expiration trading, and risk management. In two appendixes Sinclair introduces the statistically challenged reader to the concepts of distribution and correlation.

It should be noted up front that anyone looking for a math-free option trading book should turn elsewhere. But the reader needs only a decent command of high school math (algebra, logarithms, exponentiation, and calculus) to follow the text, which is laced with formulas—most of them quite simple.

I had a hard time deciding what to share in this post; I had to choose among many topics not found in the run-of-the-mill option book. I finally opted for Sinclair’s analysis of the phenomenon of pinning, where the underlying settles at or very close to a strike at expiration. If we rule out the seemingly omnipresent conspiracy theory of pinning, what accounts for the fact that a higher percentage of stocks than would be attributable to chance expire within 10 cents of a strike? As Sinclair asks, “Why does it occur at all and why does it not occur in every stock?” (p. 217)

Assume for the sake of simplicity that “the entire option market consists of a customer and a single market maker. Assume that the customer sells an option to the market maker.” The customer who seeks directional exposure will not hedge his position, but the market maker will actively delta hedge his position. “If the underlying is below the strike, the market maker will be a buyer of the underlying, and if the underlying is above the strike, the market maker will be a seller. As we approach expiration the market maker’s gamma will grow if we are close to a strike. His hedges will become larger. This creates pressure pulling the price toward the strike, and the effect becomes stronger as the time to expiry decreases.” (p. 217)

Sinclair elaborates on this dynamic hedging into expiration in terms of the other Greeks, but here let me simply summarize the four conditions that lead to pinning: large open interest, delta hedging market participants being long at-the-money options, an underlying that is not hard to borrow, and a stock that is a popular vehicle for directional speculation. How can an option trader capitalize on a market that seems highly likely to be pinned? “A short straddle is often the only practical choice, but ideally we would cap our losses by using either a butterfly or a ratio spread.” (p. 219)

I am a firm believer in understanding who’s on the other side of your trade, and Sinclair does an excellent job of portraying both sides of the option market. I also appreciated his “improper” solution of the Black-Scholes-Merton equation and his graphs of the major Greeks as functions of the underlying price. He clearly owes a debt to John Hull’s books, Fundamentals of Futures and Options Markets and Options, Futures and Other Derivatives, and the serious student of options would do well to follow his intellectual trail. Moreover, I am now inspired to go back to Sinclair’s earlier book on volatility trading. There’s never just one book!

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