As with most books on the subject of trading options, the amount of material to go through can be overwhelming. For example, with Sheldon Natenberg’s Option Volatility and Pricing, that’s roughly 418 pages to digest.
There are proper reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those just starting out or about to read the book, I have summarized the core concepts in the most important and essential chapters to help you read them faster.
The number to the right of the chapter title is the number of pages that chapter contains. It is not the page number. The percentages represent the amount of each chapter of the 418 pages in total, excluding the appendices.
1. The language of the options. 12, 2.87%.
2. Elementary strategies. 22, 5.26%.
3. Introduction to theoretical price models. 16, 3.83%.
4. Volatility. 30, 7.18%.
5. Use the theoretical value of an option. 14, 3.35%.
6. Option values and changing market conditions. 32, 7.66%.
7. Introduction to broadcasting. 10, 2.39%.
8. Volatility spreads. 36, 8.61%.
9. Risk considerations. 26, 6.22%.
10. Bullish and bearish spreads. 14, 3.35%.
11. Arbitration Option. 28, 6.70%.
12. Early Exercise of US Options. 16, 3.83%.
13. Hedging with options. 16, 3.83%.
14. Review of volatility. 28, 6.70%.
15. Options and futures on stock indices. 30, 7.18%.
16. Diffusion between markets. 22, 5.26%.
17. Position analysis. 32, 7.66%.
18. Models and the real world. 34, 8.13%.
Focus on Chapters 4, 6, 8, 9, 11, 14, 15, 17, and 18, which make up about 66% of the book. These chapters are relevant for practical business purposes. These are the key points for these focus chapters, which I summarize from the perspective of a retail options trader.
4 Volatility. Volatility as a measure of speed in the context of price in / stability for a given product in a particular market. Despite its shortcomings, the definition of volatility is still based on these assumptions from the Black-Scholes model:
1. The price changes of a product are still random and cannot be designed, which makes it impossible to predict the direction of the price before its movement.
2. Percentage changes in the price of the product are normally distributed.
3. Since the percentage changes in the price of the product are counted as compounded continuously, the price of the product at maturity will be logarithmically normally distributed.
4. The mean of the log normal distribution (mean reversion) is found in the forward price of the product.
6 Option values and changing market conditions. Use of Delta in its 3 equivalent forms: Exchange rate, Coverage ratio and Theoretical equivalent of the position. Treatment of Gamma as the curvature of an option to explain the opposite relationship of the OTM / ITM hits with the TMJ hit that has the highest Gamma. Dealing with the inverse Theta-Gamma relationship, as well as that Theta is synthetically entangled as a long decay and a short prime with Implied Volatility, as measured by Vega.
8 volatility spreads. The sensitivities of a ratio spread backward, vertical ratio spread, straddle / strangle, butterfly, calendar and diagonal to interest rates, dividends and the 4 Greeks are emphasized with specific attention to the effects of Gamma and Vega.
9 Risk Considerations. A sobering reminder to select the spreads with the lowest aggregate risk margin versus the highest probability of profit. Aggregate risk measured in terms of Delta (Directional Risk), Gamma (Curvature Risk), Theta (Impairment Risk / Premium) and Vega (Volatility Risk).
11 Arbitration Option. Synthetic positions are explained in terms of making a risk profile equivalent to the original spread, using a combination of unique options, other spreads, and the underlying product. Be careful that the transformation of operations into conversions, reversals and adjustments is not without risks; But it can increase the short-term risks of the operation while reducing the net risk in the longer term. There are material differences in the cash flows of long options versus short options, which arise from the bias of exclusive bias of a product and the interest rate incorporated in the call options, which makes them disparate compared to the options of sale.
14 Review of volatility. The different expiration cycles between short-term options and long-term options create an average long-term volatility, a medium volatility. When volatility rises above its average, there is a relative certainty that it will return to its average. Also, a reversion to the mean is very likely, as volatility falls below its mean. The turn around the mean is an identifiable characteristic. Discernible volatility traits make it essential to forecast volatility over 30-day periods: 30-60-90-120 days, given that the typical term is short credit spreads between 30-45 days and long debit spreads between 90-120 days. Reconcile Implied Volatility as a measure of the consensus volatility of all buyers / sellers for a given product, with inconsistencies in historical volatility and predictive constraints on future volatility.
15 Options and Futures on Stock Indices. Effective use of indexing to eliminate the risk of a single action. Differentiated treatment of risks from equity-settled indices (including the impact of dividend / year) separate from cash-settled indices (without dividend / year). Explains the rationale for setting the theoretical price of stock index futures options, in addition to setting the price of the futures contract itself, to determine which is economically viable to trade: the futures contract itself or the futures options.
17 Position analysis. A more robust method than simply observing the Delta, Gamma, Vega and Theta of a position is to use the relevant theoretical pricing model (Bjerksund-Stensland, Black-Scholes, Binomial) to test the scenario of changes in dates (daily / weekly) before expiration,% changes in implied volatility and price changes within and near +/- 1 standard deviation. These factors that feed the scenario tests, once plotted, reveal the relative proportions of the Delta / Gamma / Vega / Theta risks in terms of their proportionality that impact the Theoretical Price of the specific strikes that make up the construction of a spread.
18 Models and the real world. It addresses the weaknesses of these basic assumptions used in a traditional pricing model: 1. Markets are not friction-free: buying / selling an underlying contract is restricted in terms of tax implications, limited financing and transaction costs. 2. Interest rates are variable, not constant over the life of the option. 3. Volatility is variable, not constant over the life of the options. 4. Trading is not continuous 24 hours a day, 7 days a week: there are trade holidays that cause differences in price changes. 5. Volatility is linked to the theoretical price of the underlying contract, it is not independent of it. 6. The percentage of price changes in an underlying contract does not result in a logarithmic normal distribution of the underlying prices in the distribution due to skew and kurtosis.
To conclude, reading these chapters is not academic. An understanding of the techniques discussed in the chapters should enable you to answer the following key questions. In the total inventory of your business account, if it is:
- Net Long more Calls than Puts, have you predicted that Implied Volatility (IV) will increase, expecting the prices of the products traded in your portfolio to increase?
- Net Long more Puts than Calls, have you predicted that IV will increase, expecting the prices of traded products to fall?
- Net Long an equivalent amount of Calls and Puts, have you forecast IV to rise, expecting prices to deviate in a non-directional manner?
- Net Short more Calls than Puts, have you expected the IV to decrease? objective, wait for prices to fall?
- Net Short more Puts than Call, have you expected the IV to drop? But do you expect prices to go up?
- Net Short an equivalent amount of Calls and Puts, have you predicted that IV will decrease? But do you expect prices to drift in a non-directional way?