#### Options Education

Option Volatility & Pricing: Advanced Trading Strategies and Techniques

Sheldon Natenberg

As with most books on the topic of how to trade
options, the amount of material to get through can be daunting. For example,
with Sheldon Natenberg’s Option Volatility & Pricing, its about 418 pages
to digest.

There are adequate reader reviews on Amazon and Google
Book Search, to help you decide if you will get the book. For those who have
just started or are about to read the book, I’ve summarized the core concepts
in the larger and essential chapters to help you get through them quicker.

The number on the right of the title of the chapter is
the number of pages contained within that chapter. It is not the page
number. The percentages represent
how much each chapter makes up of the 418 pages in total, excluding appendices.

1 The
Language of Options. 12, 2.87%.

2 Elementary
Strategies. 22, 5.26%.

3 Introduction
to Theoretical Pricing Models. 16,
3.83%.

4 Volatility. 30, 7.18%.

5 Using
an Option's Theoretical Value. 14, 3.35%.

6 Option
Values and Changing Market Conditions.
32, 7.66%.

7 Introduction
to Spreading. 10, 2.39%.

8 Volatility
Spreads. 36, 8.61%.

9 Risk
Considerations. 26, 6.22%.

10 Bull
and Bear Spreads. 14, 3.35%.

11 Option
Arbitrage. 28, 6.70%.

12 Early
Exercise of American Options. 16,
3.83%.

13 Hedging
with Options. 16, 3.83%.

14 Volatility
Revisited. 28, 6.70%.

15 Stock
Index Futures and Options. 30,
7.18%.

16 Intermarket
Spreading. 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 makes up about 66% of the book. These chapters are relevant for
practical trading purposes. Here are the key points for these focus chapters,
which I’m summarizing from a retail option trader’s perspective.

**4
Volatility.** Volatility as a measure of speed in context of price in/stability for a
given product in a particular market.
Despite its shortcomings, the definition of volatility still defaults to
these assumptions of the Black-Scholes Model: 1. Price changes of a product remain random and cannot be
engineered, making it impossible to predict price direction prior to its
movement. 2. Percent changes in the product’s price are normally
distributed. 3. As the product’s
price percent changes are counted as continuously compounded, the product’s
price on expiry will become lognormally distributed. 4. The lognormal distribution’s mean (mean reversion) is to
be found in the product’s forward price.

**6
Option Values and Changing Market Conditions.** Use of Delta in its 3 equivalent forms: Rate of Change,
Hedge Ratio & Theoretical Equivalent of the Position.
Treatment of Gamma as an option's curvature to explain the opposite
relationship of OTM/ITM strikes to the ATM strike having the highest Gamma.
Dealing with the Theta-Gamma inverse relationship, as well as Theta being intertwined
synthetically as long decay and short premium with Implied Volatility, as
measured by Vega.

**8
Volatility Spreads.** Emphasis is on the
sensitivities of a Ratio Back Spread, Ratio Vertical Spread, Straddle/Strangle,
Butterfly, Calendar, and Diagonal to Interest Rates, Dividends and the 4 Greeks
with specific attention on the effects of Gamma and Vega.

**9 Risk
Considerations.** A sobering reminder to select spreads
with the lowest aggregate risk spread versus the highest probability of
profit. Aggregate Risk as measured
in terms of Delta (Directional Risk), Gamma (Curvature Risk), Theta
(Decay/Premium Risk) and Vega (Volatility Risk).

**11
Option Arbitrage.** Synthetic positions are explained in terms of manufacturing an
equivalent risk profile of the original spread, using a mix of single options,
other spreads and the underlying product. Clear caution that transforming
trades into Conversions, Reversals and Adjustments are not risk-free; but, may
raise the trade's nearer-term risks even though the longer-term net risk is
lowered. There are material
differences in the cash flows of being long options versus short options,
arising from the Skew bias unique to a product and the interest rate built into
Calls making them disparate against Puts.

**14 Volatility
Revisited.** Different expiry cycles between
near-term versus longer-term options creates a longer-term volatility average,
a mean volatility. When
volatility rises above its mean, there is relative certainty that it will
revert to its mean. Likewise, mean reversion is highly likely as volatility
drops below its mean. Gyration around the mean is an identifiable
characteristic. Discernible volatility traits make it essential to forecast
volatility in 30 day periods: 30-60-90-120 days, give the typical term to be
short credit spreads between 30-45 days and long debit spreads between 90-120
days. Reconciling Implied
Volatility as a measure of consensus volatility of all buyer/sellers for a
given product, with inconsistencies in Historical Volatility and predictive
constraints of Future Volatility.

**15 Stock Index Futures
and Options.** Effective use of Indexing to
remove single stock risk. Distinct
treatment of the risks for stock-settled Indexes (including impact of
dividend/exercise) separate from cash-settled Indices (absent of
dividend/exercise). Explains logic
for Theoretically Pricing the options on Stock Index Futures, in addition to
pricing the Futures contract itself, to determine which is economically viable
to trade - the Futures contract itself or the options on the Futures.

**17
Position Analysis.** ** **A more robust method than just eye balling the Delta, Gamma, Vega and
Theta of a position is to use the relevant Theoretical Pricing model
(Bjerksund-Stensland, Black-Scholes, Binomial) to scenario test for changes in
dates (daily/weekly) before expiration, % changes in Implied Volatility and
price changes within and near +/- 1 Standard Deviation. These factors feeding
the scenario tests, once graphed, reveal the relative ratios of
Delta/Gamma/Vega/Theta risks in terms of their proportionality impacting the
Theoretical Price of specific strikes making up the construction of a spread.

**18
Models and the Real World.** Addresses the weaknesses of these core assumptions
used in a traditional pricing model: 1. Markets are not frictionless:
buying/selling an underlying contract has restrictions in terms of tax
implications, limitation on funding and transaction costs. 2. Interest rates
are variable, not constant over the option's life. 3. Volatilty is variable,
not constant over the options' life. 4. Trading is not continous 24/7 - there
are exchange holidays resulting in gaps in price changes. 5. Volatility is linked to Theoretical
Price of the underlying contract, not independent of it. 6. Percentage of price
changes in an underlying contract does not result in a lognormal
distribution of underlying prices
at distribution due to Skew & Kurtosis.

To conclude,
reading these chapters is not academic. Understanding techniques discussed in
the chapters must enable you to answer the following key questions.** ** In the total inventory of your trading account, if you are …

❑
Net Long more Calls than Puts, have you forecasted Implied Volatility
(IV) to increase, expecting prices of the traded products in your portfolio to
rise?

❑
Net Long more Puts than Calls, have you forecasted for IV to increase,
expecting prices of traded products to fall?

❑
Net Long an equivalent amount of Calls and Puts, have you forecasted for
IV to increase, expecting prices to drift non-directionally?

❑
Net Short more Calls than Puts, have you forecasted IV to fall; but,
expect prices to fall?

❑
Net Short more Puts than Calls, have you forecasted IV to fall; but,
expect prices to rise?