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Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management

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Praise forTrading Options inTurbulent Markets

"Of the five basic variables that drive option pricing models, the volatility assumption is far and away the most impactful. Mr. Shover's definitive work, exploring all aspects of the world of volatility, truly is a gift to the investing public."

William Floersch, President and CEO, Fortis Clearing Americas, LLC

"There are a myriad of 'Options 101' books for the beginning options investor and painfully lengthy and dry graduate-level books on advanced strategies. Larry has found the sweet spot in between, offering a great book on intermediate option strategies. I can heartily endorse Trading Options in Turbulent Markets as THE book for investors seeking to enhance their knowledge of derivative trading and createa low-risk, high-return investment game plan."

Jon "Doctor J" Najarian, cofounder, tradeMONSTER.com

"Mr. Shover has managed to marry a thoughtful presentation of volatility as it relates to options pricing and options trading, with a narrative that goes beyond the purely theoretical and focuses on the practical implications of this 'measure of instability' (first line of Chapter 2) for those who use options. In light of the tumultuous events that have churned the global financial markets, a read on the practical implications of volatility seems prudent for all who choose to employ options."

Pat Arbor, Chairman Emeritus, CBOT, and current Director ofFirst Chicago Bank and Trust

"Shover's book offers valuable insights from his real-life experience in trading volatile markets."

Jim Bittman, Senior Instructor, The Options Institute at CBOE, and author of Trading Options as a Professional

"Larry Shover was a successful options trader in his years at CRT and a valuablemember of our team. His book is both accessible and informative, and its pages are filled with insights gained from many years of experience. Larry writes with passion and acumen, making this a book that will do more than just sit on your shelf."

Joseph Ritchie, founder, Chicago Research and Trading Group (CRT); founder and Chairman, Fox River Financial Resources, Inc.; andCEO, Rwanda Development Board

Table of Contents

  1. Copyright
  2. Acknowledgments
  3. Introduction
  4. 1. Understanding the Relationship between Market Turbulence and Option Volatility
    1. 1. Managing Risk and Uncertainty with Options
      1. 1.1. What Is Risk?
      2. 1.2. What Is Uncertainty?
      3. 1.3. Seven Lessons Learned from Market Volatility
        1. 1.3.1. Lesson One
        2. 1.3.2. Lesson Two
        3. 1.3.3. Lesson Three
        4. 1.3.4. Lesson Four
        5. 1.3.5. Lesson Five
        6. 1.3.6. Lesson Six
        7. 1.3.7. Lesson Seven
        8. 1.3.8. Lessons Summary
      4. 1.4. Understanding Derivatives
        1. 1.4.1. Options Defined
        2. 1.4.2. Futures Defined
        3. 1.4.3. Understanding Options
      5. 1.5. The Six Benefits of Options
        1. 1.5.1. Benefit One: The Ability to Leverage
        2. 1.5.2. Benefit Two: Creating Market Efficiency
        3. 1.5.3. Benefit Three: Cost Efficiency
        4. 1.5.4. Benefit Four: 24/7 Protection
        5. 1.5.5. Benefit Five: Flexibility
        6. 1.5.6. Benefit Six: Trading Additional Dimensions
    2. 2. Making Sense of Volatility in Options Trading
      1. 2.1. Volatility as an Asset Class
        1. 2.1.1. How Does Volatility Work?
      2. 2.2. Analyzing Volatility with Implied Volatility
      3. 2.3. What Does Implied Volatility Reveal?
      4. 2.4. Making Trading Decisions Based on the Disparity between Historical and Implied Volatility
      5. 2.5. Appreciating Volatility for All It Is Worth
      6. 2.6. How Volatility Really Works on the Trading Floor
      7. 2.7. Volatility and Uncertainty: Lessons for the Irrational Option Trader
      8. 2.8. Varieties of Option Volatility Trading
    3. 3. Working with Volatility to Make Investment Decisions
      1. 3.1. On Predicting the Future
      2. 3.2. Starting with Historical Volatility
        1. 3.2.1. Calculating Historical Volatility
        2. 3.2.2. How Traders Have Calculated Volatility Has Itself Been Volatile over Time
          1. 3.2.2.1. Method 1: A Piece of Paper and a Pencil
          2. 3.2.2.2. Method 2: A Piece of Paper, a Pencil, and Excel
      3. 3.3. Implied Volatility
        1. 3.3.1. Calculating Implied Volatility
      4. 3.4. Why Do Volatilities Increase as Equities Fall?
      5. 3.5. Implied versus Historical Volatility
      6. 3.6. Justification for the Disparity between Historical and Implied Volatility
    4. 4. Volatility Skew: Smile or Smirk?
      1. 4.1. Considering Some Examples
      2. 4.2. A Primer on Random Walk and Normal Distribution
      3. 4.3. Dealing with the Higher Moments of the Normal Distribution
      4. 4.4. Skew Is High, Skew Is Low. So What?
      5. 4.5. Does a "Flat" or "Steep" Skew Predict the Future?
      6. 4.6. A Fair Warning about Thinking about Skew too Much
  5. 2. Understanding Option Volatility and its Relationship to Option Greeks, Personal Decision Making, and Odds Creation
    1. 5. Extreme Volatility and Option Delta
      1. 5.1. The Misnomer of Delta and Probability of Exercise
        1. 5.1.1. Delta ≠ The Probability of Exercise
        2. 5.1.2. Probability Does Not Actually Exist in Practice
      2. 5.2. Delta Defined
        1. 5.2.1. Running the Delta Numbers
        2. 5.2.2. Portfolio Delta
        3. 5.2.3. Cardinal Rules of Delta
      3. 5.3. The Relationship between Volatility and Delta
      4. 5.4. Higher Volatility and Delta
      5. 5.5. Lower Volatility and Delta
      6. 5.6. Delta, Time, and Volatility
      7. 5.7. Delta, Position Delta, Volatility, and the Professional Trader
        1. 5.7.1. Volatility and Its Effect on Position Delta
    2. 6. Smoke and Mirrors: Managing Gamma through Volatile Markets
      1. 6.1. Gamma and Volatility
      2. 6.2. Managing Positive Gamma during a High-Volatility Environment
      3. 6.3. The Bad News: There's Always More than Meets the Eye
        1. 6.3.1. Point One
        2. 6.3.2. Point Two
      4. 6.4. Practical Considerations for Managing Long Gamma in a High-Volatility Environment
      5. 6.5. Managing Negative Gamma in a High-Volatility Environment
        1. 6.5.1. Scenario One
        2. 6.5.2. Scenario Two
      6. 6.6. Practical Considerations of Negative Gamma in High Volatility
      7. 6.7. Gamma and Volatility with Respect to Time Structure
        1. 6.7.1. The More Time You Have, the Less Gamma Your Option Will Have
        2. 6.7.2. The Less Time You Have, the More Gamma Your Options Will Have
      8. 6.8. Summary
    3. 7. Price Explosion: Volatility and Option Vega
      1. 7.1. The Relationship between Implied Volatility and Vega
      2. 7.2. Implied Volatility: Price Analogy
      3. 7.3. Option Vega and Time
      4. 7.4. Option Vega and Its Greek Cousins
      5. 7.5. Option Vega Implications
      6. 7.6. Don't Underestimate the Relationship between Volatility and Option Vega
      7. 7.7. Volatility and Vega Insensitivity
      8. 7.8. Important Concepts When Applying Option Vega in a Volatile Marketplace
      9. 7.9. Summary
    4. 8. Sand in the Hourglass: Volatility and Option Theta
      1. 8.1. Balancing Time Decay with Volatility: Mistakes Traders Make
        1. 8.1.1. Mistake #1: When Traders Don't Fully Understand the Effect of Time Decay
        2. 8.1.2. Mistake #2: When Traders Underestimate or Misinterpret Volatility and Its Effect on Theta
        3. 8.1.3. Buying Options (Negative Theta) in a High-Volatility Environment
        4. 8.1.4. If You Happen to Be in the Fortunate Position of Owning Options during an Upward Movement in Volatility, This Is What You Should Expect to Happen
        5. 8.1.5. If You Happen to Be in the Unfortunate Position of Being Short Options during an Upward Movement in Volatility, This Is What You Should Expect to Happen
      2. 8.2. Volatility and Theta: What Every Investor Needs to Know
  6. 3. Ten Proven Strategies to Employ in Uncertain Times
    1. 9. Preparing for Trading Using Volatility Strategies
      1. 9.1. The Elements of a Sound Trading Decision
        1. 9.1.1. Risk Tolerance
      2. 9.2. Developing an Approach to Options Trading
        1. 9.2.1. The Day Trader
        2. 9.2.2. The Short-Term Trend Trader
        3. 9.2.3. The Position Trader
      3. 9.3. The Mind of a Successful Trader
        1. 9.3.1. Preparing to Win Big by Losing Well
        2. 9.3.2. A Deer in the Headlights
        3. 9.3.3. The Making of a First-Class Loser
      4. 9.4. Decision Making, Options versus Everything Else
    2. 10. The Buy-Write, or the Covered Call
      1. 10.1. The Buy-Write (Covered Call) Defined
      2. 10.2. An Example of the Covered Call Strategy
        1. 10.2.1. Three Possible Outcomes
      3. 10.3. The Theory and Reality of the Covered Call
        1. 10.3.1. The Realities of the Covered Call
        2. 10.3.2. Reality #1
        3. 10.3.3. Reality #2
        4. 10.3.4. Reality #3
        5. 10.3.5. Reality #4
      4. 10.4. Covered Call Writing and Implied Volatility
      5. 10.5. Implied Volatility in Practice
        1. 10.5.1. Writing Covered Calls
        2. 10.5.2. Choosing Which Strike to Write
        3. 10.5.3. In-the-Money Call
        4. 10.5.4. At-the-Money Call
        5. 10.5.5. Out-of-the-Money Call
      6. 10.6. Managing Contracts in a Time of High Volatility or a Falling Market
        1. 10.6.1. Rolling Down the Strike
        2. 10.6.2. Doing Nothing
      7. 10.7. Effective Call Writing in a Volatile Market
    3. 11. Covering the Naked Put
      1. 10.8. Contemplating the Cash-Secured Put
        1. 11.1.1. Who Should Consider a Cash-Secured Put?
        2. 11.1.2. Definition of the Cash-Secured Put
      2. 11.2. Utilizing the Cash-Secured Put in a High-Volatility Environment
        1. 11.2.1. Example of a Profitable Cash-Secured Put Trade
        2. 11.2.2. Example of an Unprofitable Cash-Secured Put Trade
      3. 11.3. Cash-Secured Put and Volatility: Risks and Consequences
      4. 11.4. Income Strategy: Volatility as an Asset Class and Cash-Secured Puts
      5. 11.5. Position Management
        1. 11.5.1. For the Investor
    4. 12. The Married Put: Protecting Your Profit
      1. 12.1. Volatility, Downside Risk, and the Case for Portfolio Insurance
      2. 12.2. Why Buy High Volatility?
      3. 12.3. The Married Put
      4. 12.4. How and When to Use a Married Put
      5. 12.5. Example of When to Use a Married Put
        1. 12.5.1. XYZ Shares Increase from $32 to $42 per Share, and an XYZ Put Is Purchased to Protect Unrealized Profits
        2. 12.5.2. XYZ Shares Decrease from $50 to $35, and an XYZ Put Is Purchased to Protect from Further Decline
      6. 12.6. The Married Put: Limiting Loss, Neutralizing Volatility, and Unleashing Upside Potential
      7. 12.7. Married Put: A Real-Life Illustration
        1. 12.7.1. Summary of the Married Put
    5. 13. The Collar: Sleep at Night
      1. 13.1. Collar Strategy
        1. 13.1.1. What Is a Collar?
        2. 13.1.2. Consider Three Potential Scenarios at Expiration
        3. 13.1.3. XYZ Is above the Short Call Strike of $35 at Expiration
        4. 13.1.4. XYZ Is below the Long Put Strike of $27.50 at Expiration
        5. 13.1.5. XYZ Is Trading between $27.50 and $35 at Expiration
        6. 13.1.6. Summary
      2. 13.2. Types of Collars
        1. 13.2.1. The Protective Collar
        2. 13.2.2. The Appreciating Collar
      3. 13.3. Summary
        1. 13.3.1. The Flexible Collar
      4. 13.4. Conclusions on the Collar Strategy
        1. 13.4.1. The Flexible Collar Strategy
        2. 13.4.2. The Reset Collar
          1. 13.4.2.1. Benefits
          2. 13.4.2.2. Costs
        3. 13.4.3. The Revised Collar
          1. 13.4.3.1. Benefits
          2. 13.4.3.2. Costs
    6. 14. The Straddle and Strangle: The Risks and Rewards of Volatility-Sensitive Strategies
      1. 14.1. The Buying or Selling of Premium
      2. 14.2. Properties of Straddles and Strangles
      3. 14.3. Comparing Straddles and Strangles
        1. 14.3.1. The Short Straddle
        2. 14.3.2. The Short Strangle
      4. 14.4. How to Compare Historical and Implied Volatility
      5. 14.5. The Impact of Correlation and Implied Volatility Skew
        1. 14.5.1. Possible Impact #1: Implied Volatility Spike
        2. 14.5.2. Possible Impact #2: Skew of Implied Volatility
        3. 14.5.3. Possible Impact #3: Winning Small and Losing Big
      6. 14.6. An Alternative to the Naked Volatility Sale via the Straddle/Strangle: The Strangle Swap
        1. 14.6.1. Comments Regarding Path-Dependent Outcome
        2. 14.6.2. Comments Regarding a Rare Event with Both Volatility and Movement in the Underlying Share Price
    7. 15. The Vertical Spread and Volatility
      1. 15.1. Introduction to the Vertical Spread
      2. 15.2. A Trader's Reasoning for Trading a Vertical Spread
        1. 15.2.1. Reason #1: Lowering Your Net Cost, Qualifying Your Risk
        2. 15.2.2. Reason #2: Flexibility
        3. 15.2.3. Reason #3: Taking Advantage of Direction and Greeks are Contained by a Predefined Risk Profile
      3. 15.3. Designing Your Vertical Spread
        1. 15.3.1. Choosing a Debit Spread or Credit Spread
        2. 15.3.2. Choosing the Right Strike Prices on the Contracts in Relation to the Underlying Asset Price
        3. 15.3.3. Selecting the Strike Price Gap between the Contracts You Buy and the Contracts You Sell
      4. 15.4. Vertical Spreads and Greek Exposure
        1. 15.4.1. Delta
        2. 15.4.2. Gamma
        3. 15.4.3. Theta
        4. 15.4.4. Vega
      5. 15.5. Vertical Spreads as a Pure Volatility Play
      6. 15.6. Comparing Volatility's Effect on Vertical Spreads
      7. 15.7. Summary: Comparing Vertical Spreads and Implied Volatility
        1. 15.7.1. Changes in Implied Volatility during the Trade
    8. 16. Calendar Spreads: Trading Theta and Vega
      1. 16.1. Calendar Spreading—Trading Time
      2. 16.2. Risks and Rewards of the Calendar Spread
      3. 16.3. A Calendar Spread with a Bullish Expectation
      4. 16.4. Considerations and Observations for Calendar Spreads and Volatility
        1. 16.4.1. 1. Time Value and Volatility in Calendar Spreads Are not Necessarily Connected
        2. 16.4.2. 2. Implied Volatility Affects Calendar Spreads Mostly with At-the-Money Options
        3. 16.4.3. 3. Avoid Assuming Too Much about Front-Month versus Back-Month Vega
        4. 16.4.4. 4. At Extreme Prices for an Underlying Stock, Differences in Parity Appear
        5. 16.4.5. 5. Pay Attention to Long-Term Trends in Volatility
        6. 16.4.6. 6. Don't Put Too Much Emphasis on Greek Values
    9. 17. Ratio Spreading: Trading Objectives Tailor Made
      1. 17.1. How Back Spreads and Ratio Spreads Work
      2. 17.2. Back Spreads
      3. 17.3. Ratio Spreads
      4. 17.4. Greek Values and the Back Spread or Ratio Spread
        1. 17.4.1. Delta
        2. 17.4.2. Gamma
        3. 17.4.3. Theta
        4. 17.4.4. Vega
      5. 17.5. Configuring and Pricing a Back Spread or Ratio Spread
        1. 17.5.1. Pricing a Back Spread or Ratio Spread
      6. 17.6. Reconciling Volatility and the Back Spread or Ratio Spread
    10. 18. The Butterfly Spread
      1. 18.1. Setting up a Butterfly
        1. 18.1.1. The Long Butterfly and the Ratio Spread
        2. 18.1.2. The Short Butterfly and the Back Spread
        3. 18.1.3. The Butterfly Spread as a Volatility Investment
        4. 18.1.4. Butterfly Spreads and the Expiration Date
        5. 18.1.5. Call and Put Butterfly Spreads Work the Same Way
      2. 18.2. Greek Values and the Butterfly
        1. 18.2.1. Delta
        2. 18.2.2. Gamma
        3. 18.2.3. Theta
        4. 18.2.4. Vega
      3. 18.3. Structuring and Pricing a Butterfly
      4. 18.4. Trading Butterflies in a Volatile Market
    11. 19. The Iron Butterfly and the Condor
      1. 19.1. The Iron Butterfly
      2. 19.2. The Condor
      3. 19.3. The Iron Butterfly, the Condor, and a Volatile Marketplace