Acknowledgments xi

Introduction to the Second Edition xiii

CHAPTER 1 Option Pricing 1
The Black-Scholes-Merton Model 1
Modeling Assumptions 7
Conclusion 11
Summary 11

CHAPTER 2 Volatility Measurement 13
Defining and Measuring Volatility 13
Definition of Volatility 14
Alternative Volatility Estimators 20
Using Higher-Frequency Data 29
Summary 33

CHAPTER 3 Stylized Facts about Returns and Volatility 35
Definition of a Stylized Fact 35
Volatility Is Not Constant 36
Characteristics of the Return Distribution 40
Volume and Volatility 43
Distribution of Volatility 45
Summary 46

CHAPTER 4 Volatility Forecasting 49
Absence of Transaction Costs 50
Perfect Information Flow 50
Agreement about the Price Implications of Information 50
Maximum Likelihood Estimation 54
Volatility Forecasting Using
Fundamental Information 60
The Variance Premium 62
Summary 65

CHAPTER 5 Implied Volatility Dynamics 67
Volatility Level Dynamics 70
The Smile and the Underlying 80
Smile Dynamics 82
Term Structure Dynamics 90
Summary 91

CHAPTER 6 Hedging 93
Ad Hoc Hedging Methods 95
Utility-Based Methods 96
Estimation of Transaction Costs 109
Aggregation of Options on Different Underlyings 113
Summary 115

CHAPTER 7 Distribution of Hedged Option Positions 117
Discrete Hedging and Path Dependency 117
Volatility Dependency 123
Summary 129

CHAPTER 8 Money Management 131
Ad Hoc Sizing Schemes 131
The Kelly Criterion 133
Time for Kelly to Dominate 143
Effect of Parameter Mis-Estimation 144
What is Bankroll? 146
Alternatives to Kelly 148
Summary 161

CHAPTER 9 Trade Evaluation 163
General Planning Procedures 164
Risk-Adjusted Performance Measures 171
Setting Goals 178
Persistence of Performance 180
Relative Persistence 180
Summary 184

CHAPTER 10 Psychology 187
Self-Attribution Bias 191
Overconfidence 193
The Availability Heuristic 197
Short-Term Thinking 199
Loss Aversion 199
Conservatism and Representativeness 201
Confirmation Bias 203
Hindsight Bias 206
Anchoring and Adjustment 207
The Narrative Fallacy 208
Prospect Theory 209
Summary 212

CHAPTER 11 Generating Returns through Volatility 213
The Variance Premium 214
Reasons for the Variance Premium 220
Summary 222

CHAPTER 12 The VIX 223
The VIX Index 224
VIX Futures 225
Volatility ETNs 227
Other VIX Trades 229
Summary 230

CHAPTER 13 Leveraged ETFs 231
Leveraged ETFs as a Trade-Sizing Problem 234
A Long Short Trading Strategy 234
Options on Leveraged ETFs 235
Summary 237

CHAPTER 14 Life Cycle of a Trade 239
Pretrade Analysis 239
Posttrade Analysis 245
Summary 247

CHAPTER 15 Conclusion 249
Summary 252
Resources 253
Directly Applicable Books 253
Thought-Provoking Books 256

Useful Websites 257

References 261

About the Website 273

About the Author 279

Index 281