Options Quant > Strategy
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Random walk in stock market prices |
Random walk theory The random walk theory asserts that price movements will not follow
any patterns or trends and that past price movements cannot be used to predict future
price movements. Furthermore, news and events are also random and trying to predict these
(fundamental analysis) is also a lesson in futility.
For obvious reasons, the Wall Street establishment is not
thrilled about random walk theory. After all, Wall Street is in the business of analysis,
strategy and money management. However, it is a fact that about 75% of equity mutual funds
underperform the S&P 500 year after year. |
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Market neutral options portfolio vs. directional futures trading
The French mathematician Louis Bachelier in his Ph.D.
dissertation titled "The Theory of Speculation" came to the conclusion that
the
mathematical expectation of the speculator is zero and he described this
condition as a "fair game".
Unlike most trading systems, which attempt to predict
market direction, our trading model manages market risk using statistical analysis
and makes appropriate trading decisions. Remember that guessing market direction
is impossible. So, why gamble against the market?
Market forecasting is not our business
Selling out of the money options in a (near) delta neutral
combination removes much of the stress and emotional decision making that is common in
directional trading. Although all derivatives trading carries some degree of risk, if done
correctly, option selling can place your position in the market far enough away that short
term swings in the market may not dramatically affect your position. |
Uniqueness of our trading system
If you do some search on Web about options trading systems,
you will notice there is not a single back tested options trading strategy. You
will find many options price calculators and position simulators, but these tools
only analyse profit/loss for the particular option's life time. Why? Because it is very
hard to historically analyze the entire options universe, with all those strike prices and
expiration months. These analyses have been performing, but only at large financial
institutions by teams of experienced financial engineers. Needless to say, the results are
not available to the general public.
We did a lot of research in the field of quantitative
finance and managed to reconstruct the options price universe by modeling the
volatility surface. It is a well known fact that option volatility is not constant
(as it is assumed in the Black Scholes world), but depends on the strike price and time to
expiration. If you look at volatility plot against strikes, you will notice the phenomenon
of skewness and smirkness. By calibrating the volatility surface, we are able to
back test and optimize our option strategy, with acceptable errors.
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Make money in up, down or sideways markets
We at Quant Trading, LLC use a series of stress-tested, proprietary
trading models (click on the left) to take advantage of decaying option value. Our
trading approach can be described as an option selling strategy.
Options Quant Trading Program holds four (4) short
put options with different strike prices and adjusts them if necessary. The
strategy has a slight bullish bias, although the main objective is to take advantage of the option time
decaying premium. It can be successful in a non-trending market or a choppy
market (studies have shown that markets are in a non-trending or sideways pattern almost
two-thirds of the time) or if the market moves slowly lower or higher.
Options (both winning and losing positions) are rolled to new strikes
according to system rules. |
Our trading programs collect premium
These programs involve selling out of the money
options containing only extrinsic (time) value, with the expectation of
collecting the entire amount of time value premium as the underlying futures contract
remains within a wide a trading range. Through
unique construction and management of put and call combination strategies, we
aim to achieve above-average market returns on capital, with the potential to
profit in up, down and sideways equity markets.
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Selling instead of buying options We are, in effect, taking the other side of trades
from participants on both sides of the market who are attempting to pick the direction of
the underlying futures contract. Some feel that the market is going up, while others
believe that the markets will head lower. The traders who feel that the market is going up
purchase calls, while those negative on the market purchase puts.
We, in effect, are staying evenly balanced in
our positions; however, we have an advantage in doing so. With our positions we can profit on both sides of the market - as long
as the market stays within our predicted or
adjusted trading range. By trading options appropriately, we avoid all
trading mistakes that futures traders make every day, while trying to
interpret and predict the price noise. |
Options are a "depreciating asset"
When selling (or "writing") an
option, time value works for us instead of against us. The buyer of the option
pays us a premium for that option. If we sell an out-of-the-money option, the
entire value of that option is in time (extrinsic) value. As time passes, if the
market behaves favorably, the option will gradually lose it's value. This
phenomenon is known as "time decay." The Chicago Mercantile Exchange estimates
over 80% of all options sold expire worthless. Our trading programs take advantage of time decay because
when the options we sold lose value our portfolio makes money. So why aren't you selling them instead of buying
them? This is why Options Quant pursues a strategy of selling out of the money options.
Careful consideration to portfolio structure
As sellers of options, we must carefully choose the option
strike prices and skillfully manage the balance of the options portfolio relative the
market conditions. When the market moves out of some pre-determined price range, this requires us to
strategically adjust our portfolio. If we adjust our portfolio at the wrong time, or
choose the wrong type of options, money could easily be lost. It requires a high degree of
skill and knowledge to properly manage the options portfolio as the market transitions.
Remember, there is always unlimited risk of loss when an option is sold, so risk
management is always important.
We don't actively trade
Unlike many futures trading strategies, which may trade on a
daily or hourly basis, our strategy is not what we consider to be "active"
trading. Often when we sell options, we will hold that same options position for a
substantial period of time, often 3-5 weeks without making any options trade. It will sound
paradoxically, but the best results are achieved by trading less frequently, and
not more frequently.
Risk management: what to do when things go wrong?
Successful options trading is not about being correct most
the time, but about being a good repair mechanic. Obviously if the trend of the market or
the trading range changes before our 4-5 week timeframe, we would have to adjust/rebalance
our options positions at that point and get our strategy back on the profit track.
Portfolio rebalancing is an integral part of our trading
strategy. Therefore we always have a tested set of "what-if" scenarios before
putting any money at risk. To be sure, money can be lost investing in short options
portfolio. But our model says that in the long haul well positioned short
options positions will generally outperform directional trading strategies.
Is 23% per year enough?
Options selling strategies are particularly
suitable for today’s volatile and uncertain market environment. We introduce our
S&P 500 options trading programs that consistently generate returns at
acceptable risk. According to our statistical analyses and historical tests,
these programs can
produce an average annual return of 23% (+/- 10%) trading. The
strongest point of these programs is consistent profit. So, is 23% per year enough? We
believe it is! By reinvesting profits and compounding yearly, a $20,000 principal (without
yearly additions, at 23% annual ROR) grows into $1,000,000 in 19 years - try this Financial Calculator. Don't forget that Warren Buffet made
his fortune with compounding at average annual return of 26%!
