Wednesday, 25 January 2012

More thoughts on option trading

It has occured to me that I have been approaching the question of option trading by thinking of it as an add-on to the current futures trading. Alternatively, we could trade the options as the core strategy, with the futures as the overlay. Looking at the monthly results of some option trading funds, and from our own past experience of options, the key problem is identifying what might be called a "volatility regime switch", where volatility spikes upwards hugely.

The key question for option sellers in these cases is whether they are able to spot the regime change prior to them incurring the large loses that arise in such regime changes. Then you could change to trading futures as an overlay that would offset the option losses. It seems to me that there are several candidate methods to enable this regime switch to be recognised. In a long chat with Jerome, we discussed the whole number of issue this raises. Our conclusion was roughly that it would make more sense to have the options as the core strategy and put our efforts into the regime switch model. We would need to devise some way to avoid catastrophic losses, but that is usually not too hard.

This also mean that we only trade EC during the day, which would dramatically lower our trading activities. But the fact is, our current busy activity is not making enough money and we would have been much better off if we had traded options instead.

So we have been building out options book gradually and are already seeing some of the offset benefits. But it will be some time before we have a firm idea about whether this is the right thing to do. It would have been in 2011, but who knows going forward?

Meanwhile, a long article in the Sunday papers about Man Group and the problems of poor performance from AHL, down 6% in 2011 and flat now for the past three years. I know Winton are doing a bit better. I wonder how Mulvaney are doing?

One final thought. In times of low Vol, it might be possible to target a very low exit price. For instance, with high Vol, we might target 100 pts in US equities, but at low Vol this could be reduced to as low as perhaps 25 to 50. This requires data on maximum favourable excursions, which is very time consuming to compile. Another possible research project.

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