CONTENTS
While there are many different aspects to volatility trading, not all of them are suitable for all investors. In
order to allow easy navigation, we have combined the sections into six chapters (plus Appendix) that are
likely to appeal to different parts of the equity derivatives client base. The earlier chapters are most suited
to equity investors, while the later chapters are aimed at hedge funds and proprietary trading desks. We
have tried to explain the topics assuming the least amount of prior knowledge, but swiftly move onto
advanced areas in order to add the most value.
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EXECUTIVE SUMMARY...................................................................................................................... 2
DIRECTIONAL VOLATILITY TRADING ......................................................................................... 9
Option trading in practice ....................................................................................................................................... 10
Maintenance of option positions ............................................................................................................................ 17
Call overwriting...................................................................................................................................................... 20
Protection strategies using options.......................................................................................................................... 26
Option structures trading ........................................................................................................................................ 32
VOLATILITY AND CORRELATION TRADING............................................................................ 37
Volatility trading using options .............................................................................................................................. 38
Variance is the key, not volatility ........................................................................................................................... 47
Volatility, variance and gamma swaps.................................................................................................................... 50
Options on variance ................................................................................................................................................ 62
Correlation trading.................................................................................................................................................. 66
Dividend volatility trading...................................................................................................................................... 80
OPPORTUNITIES, IMBALANCES AND MYTHS........................................................................... 83
Overpricing of vol is partly an illusion ................................................................................................................... 84
Long volatility is a poor equity hedge .................................................................................................................... 86
Variable annuity hedging lifts long-term vol .......................................................................................................... 89
Structured products vicious circle........................................................................................................................... 91
FORWARD STARTING PRODUCTS AND LIGHT EXOTICS...................................................... 95
Forward starting products ....................................................................................................................................... 96
Barrier options ...................................................................................................................................................... 104
Worst-of/best-of options....................................................................................................................................... 108
Outperformance options ....................................................................................................................................... 110
Look-back options ................................................................................................................................................ 112
Contingent premium options................................................................................................................................. 113
Composite and quanto options.............................................................................................................................. 114
ADVANCED VOLATILITY TRADING........................................................................................... 117
Relative value trading........................................................................................................................................... 118
Trading earnings announcements/jumps............................................................................................................... 124
Stretching Black-Scholes assumptions ................................................................................................................. 128
SKEW AND TERM STRUCTURE TRADING ................................................................................ 137
Skew and term structure are linked....................................................................................................................... 138
Square root of time rule can compare different term structures and skews........................................................... 144
How to measure skew and smile........................................................................................................................... 149
Skew trading......................................................................................................................................................... 154
APPENDIX ........................................................................................................................................... 171
Local volatility...................................................................................................................................................... 172
Measuring historical volatility .............................................................................................................................. 174
Proof variance swaps can be hedged by log contract (=1/K2)............................................................................... 184
Modelling volatility surfaces ................................................................................................................................ 186
Black-Scholes formula.......................................................................................................................................... 189
Greeks and their meaning ..................................................................................................................................... 190
Advanced (practical or shadow) Greeks ............................................................................................................... 194
Shorting stock by borrowing shares...................................................................................................................... 197
Sortino ratio.......................................................................................................................................................... 200
Capital structure arbitrage..................................................................................................................................... 201