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).
Thursday, September 9, 2010
Wednesday, September 8, 2010
Mental toughness, part 1
Graham Jones’s Thrive on Pressure: Lead and Succeed When Times Get Tough (McGraw-Hill, 2010) was written for business leaders, but some of the principles apply equally well to traders and investors. Take mental toughness, for instance. It is an attribute that is key to success because it enables people to sustain high levels of performance under pressure. Fortunately, according to Jones, mental toughness can be developed. This task involves learning four skills: “staying in control under stress, channeling your motivation to work for you, strengthening your self-belief, and directing your focus to the things that really matter.” (p. 54)
I’m going to summarize Jones’s skills in four separate posts. Quite frankly, stretching out this theme is a way for me to minimize stress. Normally I do most of my reading on weekends, but as I said yesterday Labor Day weekend was not the most productive. I’m behind. Yes, the oats and hairy vetch are planted, but I managed to read only two books, the first of which I reviewed yesterday. (The second review is written and I’ll post it tomorrow.) Upshot: cut me some slack as I enter once again the sometimes smarmy world of self-help.
Stress, according to Jones, is the dark side of pressure. “At its best, pressure energizes and invigorates leaders. It sharpens their focus and brings out the best in them. At its worst, pressure crushes and drains them.” (p. 57) As an example of acutely severe stress he recalls a conversation he had with a “senior leader” at an investment bank during the financial meltdown. “She admitted to being clueless about what might happen next, describing it as ‘trying to manage a waterfall of uncertainty and anxiety.’” (p. 58) The source of this stress was external, but most stress, Jones argues, is self-imposed and therefore manageable. “The basic choice you have is between viewing the pressure as either positive in terms of providing an opportunity for you to thrive, or negative in that it poses a threat that results in stress and feeling anxious.” (p. 66)
Jones offers three strategies for staying in control under stress: keeping your stress symptoms under control, challenging the thinking that causes you stress, and tackling the sources of your stress.
To keep your stress symptoms under control you first have to recognize and record these symptoms—for instance, you might have poor concentration, you might doubt yourself, you might be hesitant to make decisions, you might be low on energy, you might overeat. And then you have to devise a plan to deal with these stress symptoms. There is a wide range of possible strategies, from meditation to lifestyle changes.
Your “stinking thinking” can also cause stress. Jones suggests that you identify your typical automatic negative thoughts and learn to stop them. Techniques can be as simple as thought-stopping statements such as “Take control” or imagining a red stop sign. You can also reframe your negative thoughts by asking whether there’s another way to view the situation or by trying to see your “stinking thinking” from the outside.
Finally, you have to work on the sources of your stress. Jones suggests an exercise in which you first list the demands on you, then list the supports you have at your disposal to help meet these demands, and identify the constraints that currently limit you, perhaps getting in the way of satisfying the demands. Based on these lists you can choose something that you would like to work on, maximizing your supports and minimizing your constraints. Your choice must meet the following criteria: “1. It should be in your control to do something about it. 2. The changes you wish to make should be realistic. 3. Any changes you make will have a real impact, rather than merely ‘papering over the cracks.’ 4. Any changes will start to have an impact in a relatively short time frame.” (p. 110)
(to be continued)
I’m going to summarize Jones’s skills in four separate posts. Quite frankly, stretching out this theme is a way for me to minimize stress. Normally I do most of my reading on weekends, but as I said yesterday Labor Day weekend was not the most productive. I’m behind. Yes, the oats and hairy vetch are planted, but I managed to read only two books, the first of which I reviewed yesterday. (The second review is written and I’ll post it tomorrow.) Upshot: cut me some slack as I enter once again the sometimes smarmy world of self-help.
Stress, according to Jones, is the dark side of pressure. “At its best, pressure energizes and invigorates leaders. It sharpens their focus and brings out the best in them. At its worst, pressure crushes and drains them.” (p. 57) As an example of acutely severe stress he recalls a conversation he had with a “senior leader” at an investment bank during the financial meltdown. “She admitted to being clueless about what might happen next, describing it as ‘trying to manage a waterfall of uncertainty and anxiety.’” (p. 58) The source of this stress was external, but most stress, Jones argues, is self-imposed and therefore manageable. “The basic choice you have is between viewing the pressure as either positive in terms of providing an opportunity for you to thrive, or negative in that it poses a threat that results in stress and feeling anxious.” (p. 66)
Jones offers three strategies for staying in control under stress: keeping your stress symptoms under control, challenging the thinking that causes you stress, and tackling the sources of your stress.
To keep your stress symptoms under control you first have to recognize and record these symptoms—for instance, you might have poor concentration, you might doubt yourself, you might be hesitant to make decisions, you might be low on energy, you might overeat. And then you have to devise a plan to deal with these stress symptoms. There is a wide range of possible strategies, from meditation to lifestyle changes.
Your “stinking thinking” can also cause stress. Jones suggests that you identify your typical automatic negative thoughts and learn to stop them. Techniques can be as simple as thought-stopping statements such as “Take control” or imagining a red stop sign. You can also reframe your negative thoughts by asking whether there’s another way to view the situation or by trying to see your “stinking thinking” from the outside.
Finally, you have to work on the sources of your stress. Jones suggests an exercise in which you first list the demands on you, then list the supports you have at your disposal to help meet these demands, and identify the constraints that currently limit you, perhaps getting in the way of satisfying the demands. Based on these lists you can choose something that you would like to work on, maximizing your supports and minimizing your constraints. Your choice must meet the following criteria: “1. It should be in your control to do something about it. 2. The changes you wish to make should be realistic. 3. Any changes you make will have a real impact, rather than merely ‘papering over the cracks.’ 4. Any changes will start to have an impact in a relatively short time frame.” (p. 110)
(to be continued)
Tuesday, September 7, 2010
Durbin, All About High-Frequency Trading
The subtitle of Michael Durbin’s All About High-Frequency Trading (McGraw-Hill, 2010) is The Easy Way to Get Started. Added to the subtitle might have been “if you have wads of money, a team of sophisticated programmers, and clever trading strategies.” This is definitely not a DIY manual for the novice trader.
The book is, however, a first-rate description of how high-frequency trading (HFT) fits into general market structure. It also outlines some HFT strategies and presents a balanced account of the debate over HFT. And, as promised in the subtitle, Durbin gets down to the nuts and bolts of building an HFT system in chapters that even I, who spent almost two days over Labor Day weekend resurrecting a very sick computer, could easily understand and thoroughly enjoy.
Durbin has a spate of credentials. He worked at Ken Griffin’s Citadel Investment Group and at the Blue Capital Group, and he taught at the business schools of Duke and the University of North Carolina. He is also the author of All About Derivatives (McGraw-Hill, 2005).
Durbin writes with facility and wit. Although the book is marketed as a primer, which in many ways it is, it is not dumbed down. The reader learns about elephants and icebergs, volatility arbitrage, and penny jumping as well as about processing off the core, multicasting, and auto hedging.
Here I’ll briefly summarize one high-frequency trading strategy—jumping the delta. Options market-makers strive to keep their portfolios delta neutral, but they can rarely lay off the risk of an option trade with another option trade. Instead, they often hedge their trade with the underlying stock. “The market-maker in the underlying stock can use his knowledge of this procedure to his advantage by getting in front of these delta hedges. The basic idea is to watch for large option trades, figure out which side the market-maker is on, calculate the delta of the option trade about to hit the market, and then get in front of it. For example, the stock market-maker sees in the options market data feed a trade ‘print’ for 5,000 put options on stock XYZ. The strike price on those options is roughly the same as the current market price for XYZ stock, so he know this is an at-the-money option, which, by definition, has a delta of around 50. The option trade price was executed near the current offer price for that option, so the stock market-maker can deduce that the options market-maker sold (or wrote) the option.” The option market-maker will have to sell short 250,000 shares of XYZ to hedge the puts he wrote. “Because option market-makers are often willing to pay the market spread, the most common delta hedge order is a market order. The stock market-maker—if he acts very quickly, more quickly than the options market-maker—can whack the $25.50 bid and bid $25.49. When the option hedge order to sell at market arrives, it fills at $25.49 and our lightning-fast stock market-maker gets to buy for $25.49 what he just sold for $25.50.” (pp. 69-70) Whew! That, my friends, is what computers (and brilliant computer programmers) are for.
All About High-Frequency Trading should appeal to computer geeks who want to improve their algo trading software and hardware. But it’s a good read for the rest of us as well. I was flabbergasted to realize just how many components are necessary to have an effective HFT system. Without passing judgment on whether HFT is beneficial or detrimental to the markets, I can say unequivocally that it’s not a quick and easy way to get rich.
The book is, however, a first-rate description of how high-frequency trading (HFT) fits into general market structure. It also outlines some HFT strategies and presents a balanced account of the debate over HFT. And, as promised in the subtitle, Durbin gets down to the nuts and bolts of building an HFT system in chapters that even I, who spent almost two days over Labor Day weekend resurrecting a very sick computer, could easily understand and thoroughly enjoy.
Durbin has a spate of credentials. He worked at Ken Griffin’s Citadel Investment Group and at the Blue Capital Group, and he taught at the business schools of Duke and the University of North Carolina. He is also the author of All About Derivatives (McGraw-Hill, 2005).
Durbin writes with facility and wit. Although the book is marketed as a primer, which in many ways it is, it is not dumbed down. The reader learns about elephants and icebergs, volatility arbitrage, and penny jumping as well as about processing off the core, multicasting, and auto hedging.
Here I’ll briefly summarize one high-frequency trading strategy—jumping the delta. Options market-makers strive to keep their portfolios delta neutral, but they can rarely lay off the risk of an option trade with another option trade. Instead, they often hedge their trade with the underlying stock. “The market-maker in the underlying stock can use his knowledge of this procedure to his advantage by getting in front of these delta hedges. The basic idea is to watch for large option trades, figure out which side the market-maker is on, calculate the delta of the option trade about to hit the market, and then get in front of it. For example, the stock market-maker sees in the options market data feed a trade ‘print’ for 5,000 put options on stock XYZ. The strike price on those options is roughly the same as the current market price for XYZ stock, so he know this is an at-the-money option, which, by definition, has a delta of around 50. The option trade price was executed near the current offer price for that option, so the stock market-maker can deduce that the options market-maker sold (or wrote) the option.” The option market-maker will have to sell short 250,000 shares of XYZ to hedge the puts he wrote. “Because option market-makers are often willing to pay the market spread, the most common delta hedge order is a market order. The stock market-maker—if he acts very quickly, more quickly than the options market-maker—can whack the $25.50 bid and bid $25.49. When the option hedge order to sell at market arrives, it fills at $25.49 and our lightning-fast stock market-maker gets to buy for $25.49 what he just sold for $25.50.” (pp. 69-70) Whew! That, my friends, is what computers (and brilliant computer programmers) are for.
All About High-Frequency Trading should appeal to computer geeks who want to improve their algo trading software and hardware. But it’s a good read for the rest of us as well. I was flabbergasted to realize just how many components are necessary to have an effective HFT system. Without passing judgment on whether HFT is beneficial or detrimental to the markets, I can say unequivocally that it’s not a quick and easy way to get rich.
Sunday, September 5, 2010
Becoming a polymath
When my dissertation advisor, Rulon Wells, died two years ago, a colleague wrote a tribute describing him as a formidable polymath. That phrase stuck in my mind, so when I encountered Vinnie Mirchandani’s book The New Polymath: Profiles in Compound-Technology Innovations (Wiley, 2010) I figured it was something I had to read.
It’s an interesting book, though not essential reading for the trader or investor. Nonetheless, we might all do well to think about these quotations from a chapter late in the book where ten polymaths from history join the discussion.
Michelangelo: “Lord, grant that I may always desire more than I can accomplish.”
Leonardo da Vinci: “Simplicity is the ultimate sophistication.”
Hypatia: “Life is an unfoldment, and the further we travel, the more truth we can comprehend.”
Nasir al-Din al-Tusi: “Anyone who does not know and does not know that he does not know is stuck forever in double ignorance.”
It’s an interesting book, though not essential reading for the trader or investor. Nonetheless, we might all do well to think about these quotations from a chapter late in the book where ten polymaths from history join the discussion.
Michelangelo: “Lord, grant that I may always desire more than I can accomplish.”
Leonardo da Vinci: “Simplicity is the ultimate sophistication.”
Hypatia: “Life is an unfoldment, and the further we travel, the more truth we can comprehend.”
Nasir al-Din al-Tusi: “Anyone who does not know and does not know that he does not know is stuck forever in double ignorance.”
Friday, September 3, 2010
Sarna, History of Greed
David E. Y. Sarna’s History of Greed: Financial Fraud from Tulip Mania to Bernie Madoff (Wiley, 2010) is a disappointing book. The author transforms a potentially fascinating topic into little more than an annotated laundry list. With the exception of Madoff, to whom he devotes four chapters and some eighty pages, the other varieties of financial fraud get short shrift—on average a mere eight pages each.
The book’s cast of villains is also curious in that they are disproportionately Jewish. Sarna is obviously a practicing Jew who is proud of his heritage; he starts the book with his grandmother’s disdain for luftgescheften and luftmenschen. Yet where he could easily illustrate a scam with non-Jews he often goes out of his way to find a Jewish culprit. For instance, boiler rooms are commonly associated with the Russian mafia yet Sarna doesn’t even mention them; instead, he recounts the misdeeds of Stanley Cohen and his family.
One of the more convoluted scams deals with manufacturing trading volume. The illustrative tale is based on an actual story but has been “augmented a bit with details from other stories that also all really happened.” Three men were involved—Ken, the promoter; Eli, CEO of “Dreck Minerals”; and Jacob, owner of a day trading operation. The goal was to have sustained trading volume of 150,000 to 200,000 shares a day so that Eli could get his drilling operation funded. Jacob asked Ken for a million shares to run the program and half a million for himself. Ken then asked Eli for two million shares to run the program and half a million to manage the program. Eli agreed to have his cousin Boris in Israel send two and a quarter up front; the shares would come out of the Turks and Caicos Islands. They would go to a bank account held in the name of the First Abyssinian Church of South Carolina. (As Ken explained, “I have a buddy who is a Hasid. He called a buddy of his, a rabbi in South Carolina, and he spoke to the pastor [of the black church], who made it happen for me in the spirit of ecumenism.”) The plot thickens as Ken knows that Eli will sell as much as he can into the volume that Jacob will create; he convinces four traders in Canada to buy and he himself starts to sell short as soon as the price rises. And on the scam goes.
Unfortunately, the definitive history of financial fraud has yet to be written. Sarna provides at best a starting point.
The book’s cast of villains is also curious in that they are disproportionately Jewish. Sarna is obviously a practicing Jew who is proud of his heritage; he starts the book with his grandmother’s disdain for luftgescheften and luftmenschen. Yet where he could easily illustrate a scam with non-Jews he often goes out of his way to find a Jewish culprit. For instance, boiler rooms are commonly associated with the Russian mafia yet Sarna doesn’t even mention them; instead, he recounts the misdeeds of Stanley Cohen and his family.
One of the more convoluted scams deals with manufacturing trading volume. The illustrative tale is based on an actual story but has been “augmented a bit with details from other stories that also all really happened.” Three men were involved—Ken, the promoter; Eli, CEO of “Dreck Minerals”; and Jacob, owner of a day trading operation. The goal was to have sustained trading volume of 150,000 to 200,000 shares a day so that Eli could get his drilling operation funded. Jacob asked Ken for a million shares to run the program and half a million for himself. Ken then asked Eli for two million shares to run the program and half a million to manage the program. Eli agreed to have his cousin Boris in Israel send two and a quarter up front; the shares would come out of the Turks and Caicos Islands. They would go to a bank account held in the name of the First Abyssinian Church of South Carolina. (As Ken explained, “I have a buddy who is a Hasid. He called a buddy of his, a rabbi in South Carolina, and he spoke to the pastor [of the black church], who made it happen for me in the spirit of ecumenism.”) The plot thickens as Ken knows that Eli will sell as much as he can into the volume that Jacob will create; he convinces four traders in Canada to buy and he himself starts to sell short as soon as the price rises. And on the scam goes.
Unfortunately, the definitive history of financial fraud has yet to be written. Sarna provides at best a starting point.
Thursday, September 2, 2010
How to stay motivated
“All great tasks,” Scott Berkun writes in The Myths of Innovation, “test our motivation. It’s easy to court ideas over beers and change the world with rough sketches on the backs of napkins. … in the morning light … work begins, and grand ideas become more complex than they seemed hours before. Doing interesting things in this world requires effort, and it’s no surprise we often abandon our passions for simpler, more predictable things. … Achievement demands discovering personal motivations and learning to use them. The masters in all fields are foremost great self-manipulators, orchestrating their will to achieve what the rest of us cannot (or will not). However, there is no true handbook for motivation—only a treasure map of landmarks and a handful of bones to roll.” (p. 188)
Berkun sketches some ways to get and stay motivated. Here are three.
Anger. “Use exhaust from one system to drive another.”
Crazy necessity. “Deliberately put yourself in situations where you have no way out but through.”
Pride. “Prove people wrong.”
Berkun also puts grunt work on this list, arguing that “all great ideas require grunt work. … Sometimes the only way to discover, to grow, to make something great is through learning the basic, the trivial, the mundane: sufficient repetition grants mastery of anything.” Although true, I doubt that performing boring tasks is a way to stay motivated. What it shows is discipline, a theme to which Berkun returns at the end of the chapter. “It requires discipline to seek motivation when feeling unmotivated, but that’s the difference between an artist and someone who fantasizes about being one.” (p. 191)
Berkun sketches some ways to get and stay motivated. Here are three.
Anger. “Use exhaust from one system to drive another.”
Crazy necessity. “Deliberately put yourself in situations where you have no way out but through.”
Pride. “Prove people wrong.”
Berkun also puts grunt work on this list, arguing that “all great ideas require grunt work. … Sometimes the only way to discover, to grow, to make something great is through learning the basic, the trivial, the mundane: sufficient repetition grants mastery of anything.” Although true, I doubt that performing boring tasks is a way to stay motivated. What it shows is discipline, a theme to which Berkun returns at the end of the chapter. “It requires discipline to seek motivation when feeling unmotivated, but that’s the difference between an artist and someone who fantasizes about being one.” (p. 191)
Wednesday, September 1, 2010
Baeyens, RSI
What caught my fancy early on in the book was the analogy between watching RSI fluctuations on a chart and observing a skater going up and down in a half-pipe. “The half-pipe is the RSI chart, and its extreme values of 0 and 100 are the edges where the skater seems to be suspended before accelerating down the slope in the opposite direction. The skater’s speed is highest in the middle of the half-pipe. As he zooms upward on either slope, his speed slows dramatically, then drops to zero as his course reverses.” (p. 20) Translated into the language of price movement, “a relatively small change in price can cause a big move in the RSI value when it travels around the 50-level. However, large price changes are required to move the RSI value a little, once it approaches the extremes, as if an ever-increasing momentum were required to push it up an increasingly steep slope.” (p. 21)
For those who prefer arithmetic to imagery Baeyens offers a table based on the up/down ratio required to move RSI to a given value. He uses the standard 14 lookback period. Up = (((average up last 13 days) x 13) + value up today)/14; down uses the same formula, simply substituting “down” for “up.” Here are some of the critical 50+ RSI levels and the up/down ratios: RSI = 90: up/down = 10/1; RSI = 80: up/down = 4/1; RSI = 75: up/down = 3/1; RSI = 66.6: up/down = 2/1; RSI = 50; up/down = 1/1. It doesn’t take a mathematical genius to calculate the up/down ratios when RSI is less than 50.
Baeyens sets out to debunk some of the myths surrounding RSI—for instance, that price/RSI divergence signals a possible trend reversal. Divergence, he writes, “occurs frequently, as it is inevitable, and does not warrant any special treatment. It is just one way for the RSI to escape its mathematical constraints.” (p. 27)
One of Baeyens’ theses is that it is imperative to correlate different RSI time frames such as weekly-daily-hourly or daily-hourly-15-minute “in order to assess the market conditions and anticipate high probability scenarios.” (p. 53) He then does fairly complicated channel analysis on these charts.
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Baeyens offers the reader a range of scenarios, showing in each case how RSI helps anticipate price movement. The book, some 350 pages long, is full of marked-up charts. I should caution that this is not a book for the trader who wants to automate an RSI system. I have no idea how a programmer could translate the myriad channel lines into code. But it’s an interesting, fresh look at a widely used indicator.
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