Recommended Reading: 06-18-2015

Readers repeatedly ask me for book and article recommendations, especially new traders who are interested in learning more about trading and investing.  Here is another book recommendation from my personal finance library. A complete list of all past recommendations is available on the Recommended Reading page.

Brian Johnson's Recommendation

Volatility Trading, 2nd Edition

by Euan Sinclair

The second edition of Volatility Trading by Euan Sinclair is one of the most comprehensive and insightful books on volatility trading that I have ever read. While the book uses formulas to convey mathematical and theoretical concepts, the insights in the book were clearly gained from years of practical trading experience.

The author wisely begins with an explanation of the Black-Scholes-Merton and even more importantly includes a discussion of the BSM model assumptions and its deficiencies. In his chapter on "Stylized Facts about Returns and Volatility," Sinclair explains how volatility actually behaves in the real world and offers numerous graphs to illustrate these relationships. "Implied Volatility Dynamics" goes into even more detail on how implied volatility evolves over time.

I particularly enjoyed his chapters on "Generating Returns through Volatility" and the "VIX." These chapters investigate the variance premium, its sources, and how to exploit it in practice.

There are many pearls of wisdom in the book, but perhaps the most important is Sinclair's continuous emphasis on the need to identify and systematically exploit a trading edge. When trading options, this typically means exploiting anomalies between implied and forecasted future realized volatility.

Finally, Sinclair goes beyond volatility trading and includes several detailed chapters on risk management, position sizing, and psychological pitfalls.

I have been an investment professional for over 30 years and still found new insights in this book as well as several interesting research and strategy ideas to explore.

Editorial Reviews

From the Inside Flap

Volatility, by definition, is indicative of underlying randomness. But there are patterns within the noise that can be measured and exploited. No one knows this better than author Euan Sinclair, a highly successful options trader with a doctorate in quantum chaos.

But the Second Edition of Volality Trading isn't just about the numbers. Drawing upon his fifteen years as a professional trader, Sinclair provides a fully fleshed-out approach to trading that relies as much on the all-important "human element" and the psychological and emotional biases that drive trading decisions, as it does on quantitative analysis.

Ultimately, says Sinclair, trading is about having a coherent trading philosophy and developing a rigorous system. It's about setting a goal that can be clearly expressed in one sentence, and about finding trades with a clear statistical edge. And, finally, it's about capturing that edge and sizing each trade in a way that is consistent with your goal. Everything you do as a trader must be done within this framework.

Taking an accessible, straightforward approach, Sinclair provides you with the knowledge and tools you need to create just such a framework. He walks you through the basics of option pricing, volatility measurement, hedging, money management, and performance evaluation. And he develops a Black-Scholes-Merton-based quantitative model for measuring volatility that can easily can be adapted to trading virtually any type of financial instrument.

Responding to major changes in the markets since the first edition, Sinclair has expanded his scope in this Second Edition to include coverage of the many new opportunities available in VIX futures, ETNs, and leveraged ETFs. He also:

  • Analyzes the benefits and shortcomings of an array of historical volatility measurements
  • Clearly shows how volatility behaves in the real world and how it relates to returns on underlying assets
  • Outlines methods for forecasting volatility over the lifetime of a trade
  • Supplies proven techniques for knowing when to hedge and by how much
  • Delivers strategies for aggregating positions so as to reduce the need to hedge
  • Shares priceless tips on how to boost returns through trade sizing—including techniques borrowed from the worlds of futures trading and professional gambling
  • Arms you with powerful tools for evaluating the ongoing performance of your trading activity
  • Fills you in on the latest research on cognitive and emotional biases that influence trading decisions and how to leverage them to your advantage
  • Delineates time-tested strategies for trading VIX futures, ETNs, and leveraged ETFs
  • Provides access to a companion website containing valuable spreadsheets, models for calculating volatility cones for different time periods, and simulation engines

Bringing volatility trading down to earth for even the most numbers-shy traders, as well as hard-nosed quants interested in acquiring a deeper understanding of options trading, Volatility Trading, Second Edition is an indispensable "tool of the trade."

From the Back Cover

Praise from experts for the Second Edition of Volatility Trading

"Benefitting from his experience as an option trader and his background as a physicist, Euan Sinclair gives a comprehensive and detailed treatment of theoretical and practical aspects involved in volatility trading. The style is to-the-point, focused, and honest. The book includes something rarer than a CD-ROM: humor. Heartily recommended for the practitioner, as well as the academic who wants to know."
—JESPER ANDREASEN, Danske Markets, Copenhagen

"Over the last five years, this has become the classic work on practical options trading. It has been updated to cover innovations in markets as well as additional material on behavioral finance and capturing risk premium Everyone who trades options should read this book."
—AARON BROWN, Risk Manager, AQR Capital Management, and author of Red-Blooded Risk

"Practical, engaging, and concise, Euan Sinclair's Volatility Trading remains the best book I have seen about options trading from the practitioner's standpoint. A far cry from the standard textbook treatment, Sinclair's discussion of practical topics such as trade sizing, exit criteria, and P&L management—peppered with relevant trading anecdotes—educates while countering many of the trader myths and fallacies one hears over the years. New material on trading the VIX and volatility ETFs is particularly timely and useful."
—STEVE CRUTCHFIELD, Head of U.S. Options, NYSE Euronext

Conclusion

The second edition of Volatility Trading by Euan Sinclair is one of the most comprehensive and insightful books on volatility trading that I have ever read. I highly recommend this book.

Disclosure: Trading Insights, LLC has an affiliate referral relationship with Amazon.

Print and Kindle Versions of Brian Johnson's 2nd Book are Available on Amazon

Exploiting Earnings Volatility: An Innovative New Approach to Evaluating, Optimizing, and Trading Option Strategies to Profit from Earnings Announcements.

Print and Kindle Versions of Brian Johnson's 1st Book are Available on Amazon (35 5-Star Reviews)

Option Strategy Risk / Return Ratios: A Revolutionary New Approach to Optimizing, Adjusting, and Trading Any Option Income Strategy

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Brian Johnson

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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