This month’s Futures and Options Trader has an article this month about what they call “gamma scalping”. I have heard this name before, and I never connected it to the thing they are talking about in this article. Essentially – if you are buying options, you have a view on vol, if you are delta hedging, and right about vol – you want big gamma, so you can continually buy low/ sell high.

I have talked about this with a few people lately, I figured posting a pointer to the article would be nice

-Chris

I was speaking with a few colleagues this week about dispersion trading. I though I had a basic understanding of what a dispersion trade was, but as we talked about it – I said to myself; it seems just like stat arb for volatility.

So, this weekend, as Gabe is sitting next to me playing his Legend of Zelda; I found this article @ Risk Latte. It says essentially what i thought – and even calls dispersion trading “volatility arbitrage”. I will not re-explain what the article says infinitely better than I could, but I thought it was interesting how simply connecting a concept you know to something you vaguely understand solidifies the understanding.

It is amazing how much I know that I do not know

-Chris

So – I an effort to get back in the game with my maths, I have ordered a series of books and I am planning on weekly study time. Here is my basic list:

Calculus:

• Functions and limits

• Differentiation and integration

• Taylor series

• Complex numbers

• Functions of several variables

• Gamma and beta function

• Numerical integration

Differential Equations:

• First order equations

• Second and higher order equations

• Partial Differential Equations

• Diffusion equation

• Black-Scholes equation

Linear Algebra:

• Matrices and Vectors

• Systems of linear equations

• Eigenvalues and eigenvectors

• Vector spaces

Elementary Probability Theory:

• Discrete and continuous distributions

• Simple moments (mean and variance)

• Higher moments (skew and kurtosis)

• Important distributions

• Correlation

• Central Limit Theorem

Basic Stochastic Calculus:

• Random walks/SDE

• Brownian motion and Itô’s lemma

• Basic Monte Carlo

This is taken from the Wilmott’s Maths Primer. I have been considering taking the Wilmott/ 7City CQF. I am obviously interested in continued automated trading efforts. I am relatively strong with the probability/ statistics driven work – I have done the most professionally there. I am also obviously interested in the business of trading, including more and more derivative products. I have been able to work with quants in the past to implement automated systems. The way I figure it – the more I can work directly with quants, the closer I am to doing more and more of quantitatively minded fully automated real time trading.

I will let you know how it goes – my continued maths studies.

-Chris-

I was having a demo/ discussion with the head of our London index (equity linked products) desk last week. I have effectively been working for some months on a true “cross asset blotter”. While we were talking – there was some talk about using our cross asset blotter as a “poor mans structuring tool”. This is an interesting idea… I like the idea of being able to take a pile of assets in a ‘view’ and assemble them, look at them, etc.

Currently we support vanilla option strategies, variance swaps(here,here). asian and barrier option support is being wrapped up currently (tons and tons of minor concepts like quanto/ composite, etc). Some of the other products that this particular trader brought up got me to poking around trying to learn about them:

• Range accrual products – I like this 1 line explanation : “A Range Accrual Note gets a payoff for every day that some underlying is within the specified range”. Also see: here, here, here
• Dividend swaps (div swap – here, @ wilmott, also @ wilmott )
• PV Products (not sure what he is exactly talking about here)
• Swaps – (I know the basics of swaps already, more can of course not hurt)
• Options on varswaps (interesting ‘what if’ chat here on wilmott forums, risk latte’s take)

Moreover -I am interested more and more in variance swaps, options on variance swaps and other volatility of volatility type products.The migration from exotic to vanilla
I am always curious to see what is “structured” or “exotic” today – and what will next be “flow” or “vanilla” for our desks/ the street. There is a continual flow of structured/ exotic derivatives that have higher margin/ profit potential – since people have no good model to price them. From there – people figure out how to price them – the margins shrink – volumes pick up, bang! – commoditized products!

Derivatives – those happy, explosive financial toys oh how we love em’! (too bad we keep exploding them every few years – hello CDO/ MBS death the banks are enduring!!!).

-Chris

(I had this stupid post 75% typed, and my IE crashed… Microsoft, Vista and friends have been GETTING ON MY NERVES!) 

So… I had a recent post about variance swaps. I have been thinking a fair bit about the ideas of volatility – it is after all what options are all about. It is just interesting to me how darn versitile options are. It is possible to put together really novel views of risk depending on your options strategy. Strategies focused on volatility are what I am currently working through mentally. 

How to profit from volatility
Here is a good post on volatility strategies using vanilla options. Essentially – you can put together combinations of options that allow you to “focus in on” and profit based on the volatility characteristics/ changes. They mention the concept of volatility of volatility which reminds me of some work I did in the past with a guy named Lester Ingber – really, really bright guy. 

Volatility of Volatility
Lester’s article on Volatility of Volatility. This is interesting inasmuch as it is another layer of derivation on top of volatility. The idea that volatility itself has volatility is just another example of the complex mechanics that make up the financial world we are part of. We did work in this space looking at ways to achieve “adaptation” of trading system parameters based on volatility – and on volatility of volatility. Lester’s work is excellent – I also suggest reading his CMI work here and his work on Adaptive Simulated Annealing (the work I originally found him for) is also excellent. 

Dispersion Trading 
I have also been working over dispersion trading ideas – here is a good article from IVolatility.com (Good site, I used to get IV info from these guys for implementing an ETF trading strategy based on options and opening range breakout). 

Volatility Arbitrage
Daily options report has a good set of posts on volatility arb’ing. The most recent post is pointing to potential arb opportunities between the VIX and VXN – or the S&P market and NASDAQ market. The article mentions “mean reversion of volatility” – which brings me back to a few years ago… 

Toby Crabel and Mean Reversion
Toby Crabel is a relatively famous trader that popularized (to the best of my understanding) a particular trade patter for stocks and futures based on HV ratios. Essentially - you take a short range return/ longer range return and you get a ratio. This basically says things to you like; “today the volatility is relatively low” or “yesterday the volatility was relatively high”. The idea is based on the concept that “volatility is mean reverting“. This means that when volatility is relatively high, it is more likely it will be relatively low next. Often volatility arbing strategies depend on this concept. I worked through most of the “crabel-isms” a few years back while working on automated trading strategies based on some of Crabel’s ideas. 

All of this volatility stuff does bring me back to past experiences. The difference is that in the past we were looking at this information for different reasons. Currently, I am trying to understand all the more the detailed bits and pieces that would allow you to make trades that allow you to trade a view on volatility… interesting stuff!!! 

-Chris 

 

In working on a current trader interface – I am dealing with more derivs traders. Along with other things – we will be dealing in Variance Swaps. I have good product knowledge in some areas – and in some areas – I am still learning (finance is a big world). In any case – I am always trying to understand the “business incentive” for using a particular product. In trying to understand this for variance swaps – I found this article that gave me just the angle I was looking for: The Art of the Variance Swap. Here are  a few more refs; Volatility Swaps (technical), @ Wikipedia.

 -Chris

I have been getting into the oft sited John C Hull book  – Options, Futures And Other Derivatives.

This is basically the de-facto reference to … Options futures and other derivatives, as you may have guessed. Here are a bunch of great slides that cover lots of the book’s content – plus pretty pictures   Visual aides are always particularly useful. I am well versed in futures, many option types/ strategies, many credit instruments, and FX based futures and forwards. I can certainly beef up my knowledge about when exactly someone would really apply many of the more complex techniques. I mainly want to learn the more complex exotic options and composite multi-asset strategies. While this is viewed as an excellent ‘introductory text’, it is also viewed as a ‘keep it by your side’ tool. I am sure that it will come in handy in years to come.

-Enjoy

Chris