Wednesday, June 3, 2015

Sherbin, How to Price and Trade Options

Retail options traders may remember Al Sherbin from his days as the director of research for Tastytrade. He can now add to his list of credits an excellent book: How to Price and Trade Options: Identify, Analyze, and Execute the Best Trade Probabilities (Bloomberg / Wiley, 2015).

This book is most useful for those who are familiar with the basics of options and who, following probabilities, prefer short premium trades. If your idea of option trading is buying lottery-ticket out-of-the-money calls or puts, you will either be thoroughly annoyed with this book or experience a revelation.

Unlike most options books, Sherbin’s is practical. It doesn’t replace the classic texts but complements them. As he says, his entire book is about pricing risk transference and subsequently managing that risk. He explains, among other things, how to choose a strategy, how to match it to the number of days to expiration, and how to trade earnings announcements.

What I found most valuable was his chapter on exiting trades. He uses a stripped-down version of the often maligned Kelly Criterion to design a positive expectancy strategy. Setting the Kelly percent to zero, he can “back off” one of the three variables—percentage of winners (or, if forecasting, probability of profit), average gain of winning trades, and average loss of losing trades—to create a winning formula. You can calculate, for instance, where you would have to take losses to break even if you sell strangles at a 90% probability of profit and take profits at 25% of maximum profit. For those who don’t want to risk messing up the math, Sherbin provides—on a linked website—a Kelly Criterion worksheet.

As for logging trades, he is a firm believer in keeping records. A log serves many purposes, but its main rationale is “to be able to compare expected probabilities to actual probabilities over an extended period of time.” (p. 197) From the website the reader can download a useful trading log template.

Continuing with the nuts and bolts of trading, Sherbin discusses order execution, an area where traders often stumble. He then moves on to portfolio management, which is “perhaps the most difficult area of trading.” (p. 215) He delves into a range of topics here--correlation (with yet another downloadable spreadsheet), systemic risk, trade sizing (and no, he doesn’t use the Kelly Criterion to size his positions), and early exercise.

Those who are comfortable with the idea of mechanical, probability-driven options trading or who want to learn more about how to be profitable following this approach will find Sherbin’s book a most welcome addition to the literature. It’s both smart and practical.

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