The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets
Jeff Augen (FT Press: 2008)
Books on options trading generally come in two varieties. First, there are the bloodless, esoteric academic treatises that reach truly substantive and innovative conclusions, but never bother translating that quantitative research into strategies that are useful for the individual options trader. Then there are the dumbed-down, gimmicky how-to guides that explain what covered calls and calendar spreads are for the hundredth time, but don’t even attempt to discuss the relevant theory that underlies options trading.
Happily, there are rare exceptions to these two unhelpful categories, and Augen’s book is one of those exceptions. Augen strikes a perfect balance between theory and practice: he allots plenty of space to the presentation of tradable, interesting strategies, but without skimping on any of the relevant theoretical discussion. Moreover, he adds detailed analysis of pricing changes in actual trades, and uses a novel approach to charting standard deviation spikes in individual stocks; both elements give a unique tone to the book. His prose isn’t necessarily gripping, but it certainly stays out of the way of the concepts being presented, and that’s really all one would want from an author in this genre, right?
We’ll review some of the major themes of the text before discussing a few favorite strategies mentioned near the end.
Chapter Overviews
The first four chapters are a general overview of the relevant options theory that will be necessary for an understanding of the strategies presented later on. Topics covered include the basics of options pricing, the Greeks, volatility, put/call parity, and liquidity. None of this will be new material for many readers, but two features of Augen’s discussion stand out. First, there is considerably more mathematics provided than you would get in an ordinary trading-oriented text, though the non-academic nature of this book also means that none of the formulas are off-putting or distracting if for some reason you’re not interested in the underlying theory. Second, concepts are usually introduced with regard to their importance for trading: for example, the author explains what gamma is, and then discusses how traders who ignore the effects of gamma can easily take on more risk than they intend to.
Chapters 5 and 6 present the key options strategies, including covered calls/puts, synthetic stock positions, calendar, diagonal, ratio, butterfly, and iron condor spreads. There’s even a section on hedging using the VIX. What really stands out about Augen’s presentation is, again, that he combines an adept explanation of each strategy with analysis of how a trade following that strategy should be managed under different circumstances. All books on options trading should follow this formula.
The seventh chapter presents two strategies for trading around earnings cycles: the first is a long straddle approach structured to take advantage of the rising volatility that typically leads up to earnings announcements in spike-prone stocks. The second is a strategy for exploiting the volatility collapse that often occurs after earnings are announced. Both of these strategies are sound and warrant some serious attention. The strategy outlined in chapter eight - taking advantages of price distortions around and near options expiration - isn’t quite as intuitive but is also interesting. The final chapter deals solely with the more technical and technological aspects of building a trading analysis toolset - data visualization, trade modeling, data mining, etc. - and will probably not be of interest to most retail traders. It’s actually kind of an odd end to the book; on the other hand, the author’s own data visualization methods really make the book’s treatment of volatility swings more intuitive.
Highlights
The Volatility Edge in Options Trading is one of the only books in existence to devote pages to focused discussion of iron condors and other wingspreads, although the treatment here is still rather short. When it comes to condors, Augen argues that while the options on traditional indexes often fail to reflect true risks, options on individual equities are often priced more fairly precisely because those underlying stocks are actually too volatile, and therefore that ETF options “often represent the best compromise” (188). Another point that is well made (and quite welcome, since we’re always hammering on this point as well) is that the practice of “legging in” to multi-legged trades is either counterproductive or misdirected:
Most traders succeed in beating the bid-ask spread less than 50% of the time…A trader who can reliably predict short-term 50-cent price changes should have no interest in structuring complex option positions because day trading of stocks would provide a superior return. Likewise, if a trader does not believe that he or she could generate a profit through very rapid day trading, that person should not expect to beat the bid-ask spread either. Professional traders generally caution against legging in and view bid-ask spreads as a cost of doing business.
Well said. And there are loads of little gems strewn throughout this book. Like: “Long positions should be established only when you believe that the volatility priced into the option contracts is too low. The reverse is true for short positions… Establishing a long position is tantamount to buying volatility, and short positions involve selling volatility.” (47) Perhaps the best feature of the book is that it really delivers what the title promises: an analysis of options trading that actually keeps the volatility question in center focus.