Thursday, September 9, 2010

Shover, Trading Options in Turbulent Markets

Options books that venture beyond the basics and yet are accessible to non-quants are notoriously difficult to write and sometimes just as difficult to read. Larry Shover’s Trading Options in Turbulent Markets: Mastering Uncertainty through Active Volatility Management (Bloomberg Press, 2010), while not a page turner, is nonetheless eminently readable for the intermediate options trader. No math required.

The book is divided into three parts. The first part, “Understanding the Relationship between Market Turbulence and Option Volatility,” includes discussions of risk and uncertainty, volatility as an asset class, historical and implied volatility, and volatility skew. The second part of the book explores the relationship between volatility and the Greeks, and the last part offers “Ten Proven Strategies to Employ in Uncertain Times.” The strategies are well known—buy-write (covered call), cash-secured put, married put, collar, straddle and strangle, vertical spread, calendar spread, ratio spread, butterfly, and iron butterfly and condor. But Shover sheds new light by analyzing each trade from the perspective of volatility.

Since the author has 25 years of experience trading options his analyses are often “from the trenches.” For instance, in his chapter on volatility and option vega he warns of the consequences of sloppy thinking about volatility. When the Gulf War was looming in January 1991 and UN forces threatened to start bombing Iraq on January 15, implied volatility kept jumping higher. “When the bombs finally dropped, the market saw momentous volatility. Some financial instruments moved a lot, but the implied volatilities of options collapsed quickly. Some people thought they were betting on high actual volatility, when in fact they were really more exposed to implied volatility. They were right on one count and painfully wrong on the other—and in most cases, they lost a great deal of money.” (p. 90) The same reasoning, of course, applies to trading earnings announcements.

Shover also offers helpful rules of thumb. In a vertical spread, for example, a change in volatility will cause the spread to move either toward or away from its median value. That is, a $5 spread will move either toward or away from $2.50. “An increase in volatility will cause vertical spreads to move toward their median value. The higher the volatility, the closer the spread will move toward its median.” By contrast, if volatility goes down, “all the spreads valued above $2.50 will increase in value (toward maximum value), while spreads valued below $2.50 will lose value.” (pp. 206-07)

I have read my share of options books, from the rudimentary to the mind-numbingly advanced. I am very pleased to add Shover’s book to my library. It is a book I’m sure I’ll turn to when I’m stymied by the multi-dimensional world of options trading because it spans theory and practice (and unabashedly over-weights practice).

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