Inside Volatility Arbitrage: The Secrets of Skewness (Wiley Finance)

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Product Description

Today?s traders want to know when volatility is a sign that the sky is falling (and they should stay out of the market), and when it is a sign of a possible trading opportunity. Inside Volatility Arbitrage can help them do this. Author and financial expert Alireza Javaheri uses the classic approach to evaluating volatility -- time series and financial econometrics -- in a way that he believes is superior to methods presently used by market participants. He also suggests that there may be "skewness" trading opportunities that can be used to trade the markets more profitably. Filled with in-depth insight and expert advice, Inside Volatility Arbitrage will help traders discover when "skewness" may present valuable trading opportunities as well as why it can be so profitable.

Inside Volatility Arbitrage: The Secrets of Skewness (Wiley Finance) Review

The Good: Very good review of stochastic volatility models, Heston, SVJ, etc. I say review because if you've never seen SV models before, this is most definitely not the best place to learn about them for the first time. I would instead recommend online sources (Nimalin Moodley's paper is a great introduction to the Heston Model), the Gatheral lectures at NYU and the corresponding book "The Volatility Surface" by Jim Gatheral - in fact, I recommend working through the problems from his course notes while working through the book, it will improve your experience dramatically. What Javaheri does better than Gatheral is dive into the nitty gritty of applied model calibration for stochastic volatility models, i.e. the content of Chapter 2.

The Bad: The title stinks. This book is not a sneak peek into volatility arbitrage strategies. There is a very small amount of content related to practical trading strategies, and none (zero) related to options arbitrage. Don't look here for useful trading strategies, don't expect this to show you how to run an options trading desk.

The Ugly: Chapter 3. This is just not pretty. I'm not a domain expert - I am a physicist and computer scientist with an MBA, and I am still learning when it comes to financial engineering. But I know enough finance and math to shake my head when I read this chapter. This guy looks at a few year's worth of data at a time and concludes that the options market is over-estimating skew relative to historical time series.

Umm, data sufficiency issues here? He then acknowledges this on pages 197/198 on the Peso Theory before going on to vaguely describe a few trades, i.e. going short skew or long kurtosis.

Now in addition to the data sufficiency issues, I won't say the trades he describes are *bad* arbitrage trades, since they aren't even arbitrage trades *at all*. An inconsistency between two markets is only an arbitrage if the parameters in question are tradable in both markets. The trades aren't even well fleshed out - not surprising, given the brevity of this section.

Finally, on page 219 in the "Word of Caution" section, he throws in the comment that "the skewness transaction described in this chapter is more similar to selling insurance than to an arbitrage." Oh. Gee. Might have told your editors that before they named the book.

Quick note on skew trading: if you had been in the skewness trade described in Chapter 3, I'm fairly certain you would have gotten wiped out in late 2008. There are other ideas out there of safer ways to extract some rents from the skewness discrepancy Javaheri observes. These trades are also long kurtosis to mitigate crash risk, though they still bear volatility term structure risk, and deserve a much more robust analysis than Javaheri gives to his strategies. Search around on the Wilmott forums if you are curious.

Summary:
Chapter 2 on the Inference Problem and model fitting has lots of good material, and the review in Chapter 1 of volatility models covers all the bases, while being overly dense and terse unless you are already basically familiar with most of the models described. Chapter 3 should be read as an observation of potential discrepancies in the market, with a sketch of some very basic options trading ideas, nothing more. Wiley Finance editors should be sacked for the title of this book.

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