Interview with Dr Euan Sinclair, author of ‘Volatility Trading’

Volcube put some questions to renowned options trader and author Dr Euan Sinclair about the current state of the options markets, new opportunities that have arisen and what skills new derivatives traders need to acquire to make an impact.

The VIX has spent most of 2012 so far below 20%. Do you see that changing significantly before year end?

Obviously there is always the potential for a major terrorist attack or a natural disaster to cause volatility to spike but other than that volatility seems to be at a level where prediction is hard. When volatility is very high it is a good bet it will revert to its mean (and generally fairly quickly) but it is currently almost exactly at its median value. It seems low but that is really a matter of perception as it has decreased fairly steadily lately.

What option strategies are you pursuing and researching right now?

I’m looking at “anomalies” in option prices. There are numerous studies of the anomalies displayed by stock prices. Things like calendar effects, momentum around earnings releases, the effects of weather or lunar cycles etc. There has been surprising little done on how similar things affect options. Of course, traders have speculated about these things forever but I haven’t found trader speculation to be particularly reliable.

Interesting. In Volatility Trading you discussed several different measures of realized volatility. Do you have a personal preference?

I recently decided I don’t have any basis to select a favourite. Practically all comparisons use artificially generated data with a known distribution to rank the different estimators. In trading, not only do we not know the parameters of the distribution but we don’t even know the form of the distribution. I’m currently trying to test the various estimators using an option trading based criterion. Until that work is done I’ll just continue to use a suite of estimators.

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You’re well known for strategies involving single name stock options. Do you also see opportunities in index and etf options?

There are actually some good index option trades that don’t have an analogy in the single stocks. For example, there is a persistent edge in selling index volatility as implied volatility is almost always higher than the realized volatility. This isn’t true for equity options where there seems to be no such bias. The index variance premium seems to come from the implied correlation term which isn’t present in single stocks.

Volatility Trading (2008) is hugely popular with the option trading community as well as finance graduate students. Is there a 2nd edition in the pipeline?

I actually wasn’t aware that students were reading “Volatility Trading” so that is a nice surprise. There is a new edition coming out at the start of 2013. The book will be nearly twice as long as the first edition. There will be new chapters on stylized facts of volatility and returns, using high frequency data to estimate volatility, trading VIX futures and options, dispersion trading and trading equity options over company earnings releases.

That sounds very interesting. The VIX options market has obviously surged on the CBOE since the first edition of Volatility Trading. Do you see significant opportunities there?

Absolutely. The VIX (and the numerous volatility etns) are great as hedging tools, relative value trading vehicles and as stand-alone sources of edge. The imminent launch of realised volatility futures will only add to this landscape.

And are there additional risks from trading options on a volatility index?

I don’t think “additional” is the right word. I think there are different risks. As a LIFFE trader told me once, “look mate the bund is that number up there on the board. That’s all you need to know”. At a certain level he was right. Any underlying can go up, go down or stay the same. Of course if you are spreading VIX against something else then you have additional risks, but that isn’t due to the product. That is due to your trading strategy.

You have often stressed the importance of psychological factors in trading strategies and the market generally. Do you see these factors being modelled and actively traded on?

I’m not sure how they can be modelled exactly. But we seem to have reached the stage where behavioural finance has reached the mainstream and these effects are seen as more than mere curiosities.

How do you see high-frequency or algo trading developing in the option markets?

Most large trading firms use algos now. Execution, hedging and adjusting skews are all done in at least semi-automated ways. This is inevitable when one trader might be trading options on 100 stocks. And the sort of high frequency trading that has become commonplace in stocks and futures is also beginning to be more important. It makes sense: many of the high frequency trading tricks are identical to the one’s used by floor traders. The participants and platforms may differ but there are only so many ways to buy or sell.

Do you think the derivatives market is looking for new applicants to have a different skill-set and knowledge base to say a decade ago?

Yes.

What do you think is driving that change?

As things are becoming more automated, greater familiarity with computers is essential. It is much more important to know VBA (excel is the workhorse of finance), Perl and R than it was ten years ago. Having rapport with brokers and a feel for the market isn’t going to get you a job anymore.

What do you think makes for successful option traders nowadays?

Intelligence, hard work and the humility to climb the learning curve are still vital but I would also be looking for someone with a solid background in computing and statistics, ideally time series analysis.

Euan Sinclair is an option trader with over fifteen years of professional trading experience. He has traded options on indices, stocks, commodities and interest rate products. He currently works on strategy design and is the risk manager at Bluefin Trading. He holds a PhD in theoretical physics from the University of Bristol and has written two books, “Volatility Trading” and “Option Trading”, both published by Wiley.

Euan was speaking to Volcube : Market Analysis in May, 2012.

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