Book Review - Retail Options Trading
E. Sinclair and A. Mack, 2024
This book holds the map to treasure.
This is how the book's foreword starts. Although the map is zoomed out and leaves the “last mile” of discovery to the reader, this is not far from the truth.
The book begins with an excellent discussion of market efficiency. It serves to ground the reader in thinking about one’s competition in the market. It then delves into a discussion on the essence of one’s edge, the advantage that gives a positive expectation of profitability over time. Everything else is secondary to this concept. The remainder of the book builds on these two premises, guiding the reader in thinking about extracting the edge in the face of competition.
My Key Takeaways
Always have a clear understanding of the source of return - what are you being paid for?
The taxonomy of sources of return:
Risk premia - where one person pays another to remove risk (insurance, for example) or to perform an unappealing/difficult task; risk premia have huge capacity and staying power.
Equity risk premium
Credit risk premium
Volatility risk premium (also known as the variance risk premium)
Implied volatility is usually greater than the subsequent realized volatility.
Key stats: The average volatility risk premium is 3.55, the median is 4.34, the standard deviation is 7.44, the maximum is 34.7, and the minimum is -66.51 (all stats are in volatility points). The percentage of positive days is 82.39%.
Market inefficiencies/anomalies - where there is a temporary price distortion; anomalies are transient and will sooner or later evaporate.
Timing anomalies
Such as differing volatility by day of the week, day of the month, or hour of the day.
Volatility anomalies
Mean reversion effect
Autocorrelation effect (is it trending or not?); the implication is that options of stocks that are range bound are more expensive than options of trending stocks.
Straddle breakout effect (realized volatility cycles between expansion and contraction phases); the implication is that a sequence of multiple wins in a short straddle strategy can lead to crowded positions, setting the stage for a sudden volatility expansion.
Vanna crush effect (the rebalancing of market makers’ hedges following major catalysts drives increased activity, buying pressure, and higher realized volatility).
Sentiment anomalies (predicting the sentiment of market players from put-call asymmetry, order flow, dealer implied gamma levels, etc.)
Characteristics of volatility:
Volatility has a negative correlation to returns.
Volatility has a positive correlation to its own volatility.
Volatility clusters in the short-term.
Volatility mean-reverts in the long term.
Trade structure selection to directly harvest volatility risk premium:
ATM Straddle
Pros: Most vega for a given expiration, i.e. exposure reached with the smallest number of options; the winning percentage gives the most accurate measure of one’s ability to time the volatility risk premium.
Cons: A big stock move will reduce vega and make the P&L fairly path-dependent; ATM options have the most gamma so will require the most adjusting to remain delta-neutral.
Strangle
Pros: Vega exposure is less dependent on the stock’s movement; selling OTM options benefits not only from the volatility risk premium but also from skew.
Cons: More options are needed to reach desired exposure; a higher winning percentage can obscure one’s true ability to time the volatility risk premium.
Iron Condor
Pros: Low margin requirements and defined risk.
Cons: This structure has much less edge as one pays a steep price for the protection of the “wings”; high transaction costs.
The difficulty of timing the risk premium should not be underestimated. For example, being out of the market will, on average, result in missed profits, so the timing ability needs to be very high. The authors calculate that one’s predictive accuracy must exceed 82.8% to outperform simply holding SPY.
The right mindset to think about finding and extracting market inefficiencies is that of a bank robber. One robber may notice the reinforced concrete, the cameras, and the guards. The second robber may notice the lunch-break schedules, times the vault opens, camera dark spots, and the layout of ventilation ducts. The market tends to be efficient, and one needs to focus on finding the inefficiencies like the second robber. Some of the examples that the authors include are low liquidity and behavioral biases (such as recency bias).
You should not hedge to make yourself comfortable; rather, if you hedge, you should hedge only to the extent to avoid the risk of ruin.
Where to play:
Focus on what’s hot
Avoid areas that require significant informational depth (such as commodities). Moreover, commodities exhibit low and inconsistent volatility risk premiums.
The authors dedicate one chapter to trading psychology. Some insights that cut deep include:
“With our thoughts, we create the world” - Buddha
Be self-aware, mindful of your emotional states, and explore your biases and inner voices.
Seek support and mentorship.
Perfection in one’s process - do you want to be right often (i.e. take a swing at the obvious winners only), or are you ok with being wrong a lot (i.e. miss a lot of shots)? The authors suggest that for actual trades and their results, one should expect to be wrong often and focus on the process rather than the results.
Accept that trading is a struggle - if you want to make a profit, you need to take risk and be uncomfortable.
Don’t make trading the basis for your self-esteem.
Treat moods as different “team members” - adjust what you do based on your mood.
Depressed - mindless data cleaning.
Energized - write code.
Contemplative - research.
“Plans are worthless, but planning is everything” - D. Eisenhower
Trying harder won’t work. To get different results, you need a different process.
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