Monday, June 3, 2013

Sinclair, Volatility Trading, 2d ed.

Euan Sinclair has a Ph.D. in theoretical physics, which means he knows his way around the world of mathematics. Any reader who has difficulty deciphering (mainly statistical) formulas may find parts of this second edition of Volatility Trading (Wiley, 2013) challenging. But, even for him, all is not lost. Most of the book is written in clear English prose.

Volatility is a slippery concept. First of all, it encompasses three separate “time-stamped” notions: historical volatility, implied volatility, and future realized volatility. “[To] find an edge in option trading, we need an estimate of future realized volatility to trade against that implied by the options. But before we can forecast future volatility we need to be able to measure what it has been in the past.” (p. 13) And measuring historical volatility is no easy task. Sinclair analyzes five estimators: close/close volatility, Parkinson volatility, Rogers/Satchell volatility, Garman/Klass volatility, and Yang/Zhang volatility—each with its own strengths and weaknesses. He concludes that “there really is no indication that any one estimator is best. All measures contain information. … For example, if the Parkinson volatility is 40 percent and the close-to-close volatility is 20 percent, we can reasonably conclude that much of the true volatility is being driven by large intraday ranges and that the closing prices underrepresent the true volatility of the process.” (p. 28) In the end, Sinclair concludes, “volatility measurement is something of an art.” (p. 33)

Qualitative considerations are also prominent in stylized facts (features that are consistent enough to be generally accepted as truth) about returns and volatility. Sinclair lists the following:

  • Volatility is not constant. It mean-reverts, clusters, and possesses long memory.
  • Large returns occur relatively frequently. These large moves have subsequent aftershocks.
  • In most markets, volatility and returns have a negative correlation. This effect is asymmetric: negative returns cause volatility to rise sharply while positive returns lead to a smaller drop in volatility.
  • Volatility and volume have a strong positive relationship.
  • The distribution of volatility is close to log-normal. (p. 36)

The author offers outlines of some trading strategies, all requiring additional work on the part of the reader. As he admits, “Edge estimation and capture are difficult and both involve subjective judgment.” (p. 131)

In the second half of the book Sinclair moves on to other essential ingredients of trading success, starting with money management. He first analyzes the Kelly criterion and alternatives to Kelly. A second ingredient is trade evaluation, better known as record keeping. “Without accurate and comprehensive records it is easy to fall victim to selective memory biases. We all tend to remember the few big wins and big losses. But these are unlikely to be typical of our trading, and basing decisions on how these trades alone worked out would be unwise. Trading is largely about making solid, unspectacular plays—precisely the ones that we tend to forget.” (p. 163) In summarizing the chapter on trade evaluation, Sinclair writes: “The easiest way to improve is to keep detailed records and then review them. Not only is this necessary to improve but merely doing it almost guarantees improvement. It forces us to take ownership of our successes and failures and helps us to see exactly what we can and cannot do.” (p. 184)

Re-read those last three sentences. They may be the most important thing you take away from this post even though they are not the cornerstone of Sinclair’s analysis.

I, of course, was also attracted to the brief chapter on resources, both books and websites, and found a couple of real gems there.

Volatility Trading is not for the novice options trader. But neither is it simply for the quant. It addresses a range of issues—including some, such as behavioral finance, the VIX, and leveraged ETFs, that I have not touched on here. Odds are that the intermediate to advanced options trader will experience some “aha” moment reading this book.

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