Option Volatility and Pricing: An interview with Sheldon Natenberg (Part 1)

On September 9, 2023, Kevin D of Quantitative Traitor interviewed Sheldon Natenberg, author of “Option Volatility and Pricing: Advanced Trading Strategies and Techniques” and former director of education at Chicago Trading Company. What follows is a lightly edited transcript of the interview.

Thanks to Alex W., Michael S. and Kaushik K. for some help with formulating questions.

Kevin D: How do you feel mean reversion plays into managing options risk when underlying and volatility markets have such large tail events?

Sheldon Natenberg: You’d be better off asking a theoretician. When you look at volatility, you always assume there will be some mean reversion. I don’t know that the tail events factor into that. But they factor into the fact that volatility is supposed to be based on a log-normal distribution, and we certainly know the real world isn’t a log-normal distribution. I’m not sure that has anything to do with mean reversion, though.

KD: Do you think the growth of derivatives markets has led to certain financial institutions holding too many short convexity positions?

SN: I have no idea what financial institutions are holding. When you’re a floor trader, you have a very narrow view of the world. You just see what’s right in front of you, and you don’t see what’s behind all that. I wouldn’t have any idea what types of positions financial institutions — insurance companies, pension funds — are holding.

Just remember, I’m not an academic, even though I do education. Your two questions so far would be more appropriate for finance professors.

KD: What do you think is the best way for a fledgling trader to really understand the risks of various options positions?

SN: The best way to understand risk is to go out and trade, whether live or on paper. I tell new traders to go out and try as many different strategies as possible, but do them very small. If you buy or sell a straddle one time, it’s pretty unlikely you’ll lose a lot of money. You may lose some money, but you learn by doing. No matter how good an education you get in the classroom, there’s no substitute for the real world experience.

You do a strategy. If you made money, why did you make money? Were you right about the direction? Volatility? Or were you just lucky? If you lose money, you ask the same questions. Learning from your experience is key.

KD: Given that you grew up in an era where most people, including market makers, traded a relative value style, do you think the recent shift towards more HFT-esque trading will continue to dominate or if there will always be a healthy balance between the two?

SN: I’m not current on what’s going on in the markets because I’ve been retired for a while. However, options have never lent themselves to high-frequency trading. HFT is something that stock and futures traders do because there’s too much going on in option markets at one time. If you’re high-frequency trading, you’re buying and selling certain contracts back-and-forth. But when you do options, you have so many different contracts that it would be hard for a high-frequency trader to keep track of the risk. Risk management is the key to option trading.

KD: In 1982, you began your trading career as an independent market maker in equity options at the Chicago Board Options Exchange. What was it like starting out?

SN: Scary. My brother brought me into the business — he had been a trader for several years. I started in a pit which traded Bristol-Myers stock — today it’s Bristol-Myers Squibb, it’s a pharmaceutical company.

There was a friend of my brother in that pit, and he was trying to get me to not freeze up. He asked me for a market in a certain option. I looked at the board, and I just quoted what was on the board — the bid and the ask price. He said he’d sell me one option. Then he asked me for the market in the same option. I quoted the same price because conditions hadn’t changed, and he said now he’ll buy one option. He sold me one option at the bid price and bought one option at the offer price, and he said I made $6.25 — the minimum increment back then — now I’m on my own.

It’s like stage fright. You go on stage, you’re an actor or actress — the first time is very scary.

KD: That was when you had your Midwest Stock Exchange seat. You traded on the MSE for a few months, and then you got a full seat on the CBOE and traded IBM over there.

SN: There was more opportunity there. I didn’t buy a full seat, couldn’t have afforded it. I rented a seat for a while and traded IBM stock. There were some other companies trading in that pit. One of them was Capital Cities Communications, which I didn’t trade. They owned ABC, the American Broadcasting Company.

I got used to watching market activity, trying to learn as I went along and not to trade in too big a size because I was still a new trader. I traded there for a few months, then I moved over to the Chicago Board of Trade.

KD: During your MSE and CBOE period, what was going on in the equity options markets?

SN: The interest rates were very high, and that affected markets everywhere. You could hardly afford a mortgage if you wanted to buy a home. Interest rates were somewhere in the 14-15% range — that’s much higher than they are today. Paul Volcker was chairman of the Federal Reserve, he was trying to get interest rates to come down. There were a lot of changes in market conditions as interest rates went up and down, and that affected the market in general. You also had specific events that affected a particular stock like IBM.

KD: Walk me through a day in the life of Sheldon Natenberg back then on the CBOE.

SN: Trading started in those days at 9 AM Central (nowadays it starts at 8:30 AM Central), which was the same time that the New York Stock Exchange started, 10 AM Eastern. I’d come in at 7:30 AM, go over my positions and check for out trades, which are mismatched trades where you reported one trade and the counterparty reported a different trade — you had to rectify the trades before trading opened that day. I fortunately didn’t have many out trades, but I heard stories where there were large disagreements over an out trade.

So I’d make sure everything balanced in my account, then I’d walk over to the floor. I’d go in early to the clearing firm, the firm that cleared my trades. I didn’t have an office, but that’s where the traders sat before the opening of trading and after the close of trading. I went over there, then I went over to the floor. We waited for the opening bell, and then we just started making markets and trades — we did that until trading finished at 3:15 PM.

If it was slow, I went to lunch. But if there was a lot of activity, I avoided lunch — I didn’t break for anything because I didn’t want to miss any opportunities.

KD: One question a retail trader might ask a market maker is, what’s your favorite trade or trading strategy — tell me how you’d respond to that.

SN: Market makers don’t get to necessarily choose their strategies. They try to profit from the bid-ask spread. If you quote a market and somebody says they want to sell, you have to buy — that was your obligation on the exchange floor.

A market maker makes a trade, which becomes just another trade in his account. A market maker isn’t interested in whether he bought or sold a straddle yesterday or did a butterfly vs. calendar spread.

Market makers can adjust their bids and asks to encourage and discourage certain positions. However, they’re really trying to manage their risk throughout the day so that they don't have too big a position where if market conditions go against them, they’ll be hurt badly.

The other side of a market maker is a market taker. Customers are market takers — they can choose their strategies, when to enter and exit the market. Market makers don’t have those advantages, but they get to buy at the bid and sell at the offer, as well as having very low transaction costs.

Now, what a market maker might do is lean a little bit long on the market — I think the stock is going up — or a little bit short — I think the stock is going down. Or lean a little bit long or short in terms of volatility. But to say so-and-so loves a particular strategy doesn’t apply to a market maker.

KD: You traded on the CBOE for 2 years. What were some of the things that changed over time during your tenure, and what stayed the same?

SN: They built a new building, which was a big event. CBOE was called the Chicago Board Options Exchange because it was set up by the Chicago Board of Trade. Originally — this was before my time — they didn’t know where to put the options exchange, so they started in the lunch room at the CBOT. Then they cleared some floor space for the CBOE at the CBOT. They pretty quickly outgrew it, so they decided to build their own building right across the street from the CBOT — it opened sometime around 1983.

The effect of technology on the markets — what we now consider normal was off-in-the-future. You wrote up all your trades by hand and put them in a little conveyor belt, which went to a central area where all the purchases and sales were matched. Pretty unsophisticated, not much in the way of technology.

KD: Around 1984, the CBOT began trading listed options on treasury bonds, and you leased a commodity option market (COM) seat on the CBOT and traded there for about a year. Tell me about that.

SN: There was a very big pit. It was much different from the CBOE, which was divided up by stocks and had smaller pits with 6-8 traders each. With the CBOT, all the treasury bonds were traded in one pit. 20-40 traders were all competing with one other. It was a bigger arena and venue, and you had to get used to it.

You also had to get used to the fact that they traded in 64ths and 32nds, which isn’t normal for most people. I was a little bit used to it because the CBOE traded in 4ths, 8ths, and 16ths, but the 64ths and 32nds at the CBOT took some getting used to.

There’s a difference between trading options on futures and stock, which primarily has to do with the cash flow. If you buy or sell stock, money changes hands — you buy stock, pay for it, sell it, receive money. When you buy and sell futures, no money changes hands — you have to come up with margin. There are different cash flow considerations in futures vs. stock options markets, which also took some getting used to.

KD: Then the CBOT listed agriculture options, and you bought a COM seat, allowing you to trade all options on the CBOT. You went on to trade grain options for 14-15 years. Tell me about that.

SN: They opened grain options in 1986. That represented new opportunities, so I crossed from the bond to the agriculture room at the CBOT. I traded soybean options for a while, then corn options — I bounced back -and-forth. You got acquainted with the big players in those markets — Cargill, Archer-Daniels, many big companies you normally didn’t have in stock markets. You had brokerage firms in stock markets, but you didn’t have these big agricultural companies that traded internationally.

I traded there and enjoyed it. The trading hours were significantly shorter — started at 9:30 AM and closed at 1:15 PM. Very civilized hours, only 3 hours and 45 minutes.

During that period, I got interested in education. When I first started at the CBOE, the clearing firm that I used — First Options of Chicago — had an educator who was very good. I always had in the back of my mind that that might be something I’d like to do. Some futures-trading friends over at the CBOT who weren’t nor wanted to become option traders wanted to understand the option markets, and they asked me to run an informal class for them. There were only 4-5 people. I ran these informal classes and started to think about education more seriously. I ran some classes on my own, charging people a small amount. Then 1-2 firms on the floor asked if I would run classes for their traders, so I did that. Then I got a request from the Chicago Mercantile Exchange to run classes for them. I also ran some classes for the CBOT free of charge since I was a member donating my time. That was the start of my education career.

KD: In IBM there wasn’t too big a difference between volatility of July and October options, but in grains, there could be due to different underlyings. Tell me about that.

SN: For financial options, you had similar volatilities — could be high, could be low — regardless of the time of year. But agricultural markets are so sensitive to weather, droughts, floods etc. The summer months, which are much more susceptible to weather events, traded at much higher volatilities than the winter months.

That’s probably not quite as true nowadays since there’s a significant agricultural market in South America — their seasons are reversed. That would reduce some of the volatility in US markets, due to the markets being very interconnected. My experiences probably aren’t as pertinent today as they were when I started.

KD: How did you acclimate to how margin worked? 

SN: Option traders typically hedge their option positions with positions in the underlying contract. If you’re a stock or futures option trader, you’re constantly buying and selling stock or futures, respectively, to hedge your option position. When you trade options, the profits and losses only appear on paper until you close the position. With futures, the profits are immediate, what they call variation margin. If the futures market goes against you, you immediately have a cash outflow, you have a debit.

You could have a big profit in options and a big loss in futures, with your options profit exceeding your futures loss. However, you have to come up with extra cash because your option profits are only on paper until you close a position, but your futures losses are immediate. You become sensitive to your futures position sometimes without regard to your option position — you look at the positions overall, but you’re certainly aware of your futures position. We sometimes refer to the fact that you might have to come up with more cash if the futures go against you as a mixed settlement procedure. The options are settled one way, the futures another. This primarily applies to the US because most overseas futures exchanges don’t use a mixed settlement procedure, they use uniform for the options and futures so you don’t have the cash flow problems you might in the US.

KD: How did your time on the CBOE and CBOT differ?

SN: They used to joke that futures traders are the best traders in the world because they react very quickly, and option traders are the smartest traders in the world because they can make lots of calculations in their head and use that to make better decisions. If a futures trader misses a trade that might have been profitable for him, he can get very upset because that trade is gone. As an option trader, it wasn’t the end of the world if I missed a trade — these things come back. More important was making intelligent decisions given the information I had at the time.

KD: How did your market making e.g. risk-management approaches change from equity to commodity options?

SN: They didn’t change all that much. But in commodity options, especially in agricultural markets, calendar spreads were very sensitive to seasonal volatility. Also, you had different underlying contracts. In IBM, the underlying contract is always IBM stock — there’s no difference between IBM stock in January and February other than the price.

In futures markets, there are different underlyings for each option. If you were trading March and May options, the underlyings were March and May futures respectively. Those futures didn’t necessarily move together in lockstep. One futures market could go up and another could go down due to seasonal influences. It was more complicated in that respect, but I don’t want to overemphasize it — you just get used to it.

KD: You continued trading at the CBOT until 2000. What were some of the things that changed over time during your tenure, and what stayed the same?

SN: They opened a lot more options at the CBOT. They started with treasury bonds — originally US government treasury bonds were 30 years, now they trade 2, 5, 10 year treasury notes. Then they opened grains, followed by grain derivatives, soybean oil and meal. And they started to trade silver. They have a much broader product base than they did when I was there — it was really just treasury bonds in the beginning, then the agriculturals for quite a while, then they started to open other products.

The big changes occurred with electronic trading after I left the floor. Electronic trading really replaced floor trading for futures markets, not necessarily for option markets.

KD: Tell me more about the automation and electronification of trading that went on during the CBOE and CBOT eras.

SN: The CME introduced Globex towards the end of my time on the floor. You could see the writing on the wall. Exchanges I did some education for outside the US went very quickly from floor to electronic trading, and then the US followed. There were no open outcry floors at all left in Europe and most of the world when I left the CBOT, they were all electronic — maybe Australia still had some floor traders. Everybody knew that it would eventually catch up with the US.

They still have open outcry for many option markets in the US because you can’t easily execute more complex strategies on electronic platforms. They’re getting there. But if you want to trade a butterfly or multi-legged option strategy, it’s usually best to go onto the floor and yell out what you want to do (or have your broker yell for you), and you’ll usually get a tighter market than you would on an electronic platform, although I shouldn’t make assumptions about what conditions are right now because I’ve been away from the markets for quite a while. But we still have open outcry option markets in the US.

KD: What are some market-making approaches that were possible during your career on the trading floor that got wiped out, or at least made harder, with the transition to electronification?

SN: Markets have become much more efficient. Many retail customers today know as much about options as market makers. There’s more education and sophistication. I trade a bit as a retail client now, and I get fills that I would’ve never expected to get as a retail client 20-25 years ago — markets are tight, everybody’s competing, there’s almost instantaneous transfer of information, you’re able to know things that a market maker knows at almost the same time. Many market-making firms have closed up shop because the competition is so tight, profit margins are smaller. Market makers in the 1990-2000s could expect to do very well trading the bid-ask spread, but that’s pretty difficult now due to the bid-ask spread having become so tight. For example, now it’s 23 cents bid at 27 cents instead of 20 cents bid at 30 cents. Market makers don’t have the edge they used to have.

KD: What about trading was hard to learn starting out?

SN: When you go into a pit for the first time, you represent new competition. There was pushback from the other traders in the pit because you would take some of their opportunity away. You had to be patient until you were accepted. Also, you had to learn to get along with the other traders and brokers in the pit. It was a little community — if you antagonized people, they wouldn’t trade with you. People with off-putting personalities found it very difficult to acclimate to floor trading. With electronic trading, the computers don’t have personalities, so you don’t have to worry about that. But people have personalities, and you have to get along with the community in order to get your fair share of trades. ■

TO BE CONTINUED…