Trading Options for Edge

Mark Sebastian is the CIO of Karman Line Capital and founder of Option Pit LLC, and a former member of both the Chicago Board Options Exchange and the American Stock Exchange. He is the author of the trading manual The Option Traders Hedge Fund and a frequent guest on CNBC, Fox Business News, Bloomberg, as well as a contributor to The Street’s Real Money Pro. He has been published nationally including on Yahoo Finance, and quoted in the Wall Street Journal, Forbes, Reuters, and Bloomberg. Mark has spoken for the Options Industry Council, CBOE, ISE, CME, and is a co-host on the Option Block podcast and Volatility Views podcast. He has a Bachelor’s in Science from Villanova University.

Part I: Professional Lessons Every Trader Needs to Know  1

Chapter 1: Trading in Options  3

The TOMIC  4

Build an Infrastructure  5

Build a Trading Plan  6

Select Trades Based on Articulated Criteria  7

Manage Risks  8

Learn All the Essential Elements of Trading  9

Chapter 2: Risk Management  11

The Pricing Model  12

Delta  12

Change in Underlying Price  14

Change in Strike Price  15

Time to Expiration  15

Volatility  16

Gamma  17

Price of the Underlying  19

Strike Price  20

Time to Expiration  20

Volatility  22

Vega  25

Price of the Underlying  25

Strike Price  26

Time to Expiration  27

Volatility  28

Theta  29

Price of the Underlying  29

Strike Price  30

Time to Expiration  33

Chapter 3: Market Makers, Risk, and the Individual Trader  35

How Market Makers Make Money  35

Skew  38

Term Structure  39

Market Maker Size  39



Market Maker Global Risk  41

Chapter 4: Volatility  43

Realized Volatility  43

Zone 1 Ultralow Volatility  43

Zone 2  46

Zone 3  47

Zone 4  50

Implied Volatility  51

Zone 1  52

Zone 2  52

Zone 3  53

Zone 4  54

Chapter 5: What Is Edge?  57

Edge  57

10 Day HV  58

20 Day HV  59

60 Day HV  59

Review the IV of the Product  60

IV30  61

Term Structure  62

Skew  63

Know the Zone of the Market  65

Select the Trade  67

Chapter 6: Locking in Edge  69

The Retail Trader  70

Establish the Option You Want to Execute  70

Establish the Offsetting Contract  71

The Hard and Soft Side of a Trade  71

Execute, Manage, Exit  73

Part II: Using Spreads  75

Chapter 7: A Quick Review of Spreads  77

The Call Spread  77

The Put Spread  79

The Straddle  82



Short Straddle  83

The Strangle  85

The Iron Butterfly  87

The Short Iron Butterfly  87

The Long Iron Butterfly  91

Standard Butterfly  92

The Iron Condor  94

The Short Iron Condor  94

The Calendar Spread  97

The Long Calendar  97

Short Calendar  99

Front and Back Spreads  100

Back Spreads  100

The Front Spread  101

Chapter 8: Adding Edge to Spreads  105

Credit/Debit Spreads  105

Volatility  108

Skew  110

Management  113

A Few Words on Adjusting  115

Chapter 9: Butterflies and Condors  117

The Butterfly  117

Trading a Butterfly  119

Targeting Profit in a Butterfly  124

Condors  124

Strangle  125

IV and HV  126

Skew  128

Set Up and Management  129

Chapter 10: The Front Spread  131

What Is a Front Spread?  131

Creating a Front Spread  132

IV  133

Skew  136

HV  137

The Broken Wing Butterfly  138



Trade Management  139

Aggressive Management  139

Passive Management  139

Beginning of Front Spread in TSLA  140

Target Profit  142

Broken Wing Butterfly Variation  142

Chapter 11: Calendar Spreads  145

Creating a Calendar  146

Evaluate Overall Implied Volatility  147

Evaluate Term Structure  148

Evaluate Event Risk  149

Evaluate Realized Volatility  150

Choose the Right Strikes  151

Execute the Trade  152

Manage the Trade  154

Exit  154

Part III: Gobal Risk  155

Chapter 12: How a Market Maker Trades  157

Market Making  157

The Trader  160

Step 1  161

Step 2  161

Step 3  161

Step 4  162

Chapter 13: Portfolio Greeks  165

Delta  165

Gamma  166

Theta and Vega  167

Theta  167

Vega  168

Managing a Book  172

Chapter 14: Crisis Alpha  175

Defining a Market Crisis  175

Lehman Brothers Bankruptcy  176



VIX Term Structure Determines ‘Value’ for VIX Derivatives  177

Crisis Alpha Approaches  179

Approach 1: Tactical Long VIX  179

Approach 2: Low Cost-of-Carry Options Structures  182

Exit Strategy  184

Part IV: Appendices  185

Appendix A: Important Terms  187

Historical Volatility (HV)  187

Short-Term Historical Volatility  187

Intermediate-Term Historical Volatility  188

Long-Term Historical Volatility  189

Realized Volatility (RV)  190

Forward Volatility  192

Implied Volatility (IV)  192

Calls and Puts  193

Skew  194

Term Structure  196

Volatility Index (VIX)  197

Delta  198

Gamma  199

Theta  201

Vega  202

Appendix B: Best Blogs  205

Index  207