Strategies Considered in This Book
The nature of options makes it possible to create a considerable number of speculative trading strategies. Those can be based on different approaches encompassing the variety of principles and valuation techniques.
In many strategies options are used as auxiliary instruments to hedge main positions. In this book we are not going to delve into this field of options application since hedging represents only one constituent part of such trading strategies, but not their backbone.
Options may be used to create synthetic underlying positions. In this case the investor aims for the payoff profiles of an option combination and its underlying asset to coincide. This can increase trading leverage significantly. However, apart from leverage, automated trading of synthetic assets is no different from trading in underlying assets (besides the certain specificity regarding execution of trading orders, higher brokerage commissions, and the necessity to roll over positions). Thus, we will not dwell on such strategies either.
Most trading strategies dealing with plain assets (not options) are based on the forecast of the direction of their price movement (we will call them directional strategies). Options can also be used in such strategies. For example, different kinds of option combinations, commonly referred to as spreads, benefit from the increase in the underlying price (bull spreads), or from its decline (bear spread). Despite the fact that trading strategies based on such option combinations possess many features distinguishing them from plain assets strategies, the main determinant of their performance is the accuracy of price forecasts. This quality makes such strategies quite similar to common directional strategies, and therefore we will not consider them in this book.
The focus of this book is on strategies that exploit the specific features of options. One of the key differences of options from other investment assets is the nonlinearity of their payoff functions. In the trading of stocks, commodities, currencies, and other linear assets, all profits and losses are directly proportional to their prices. In the case of options, however, position profitability depends not only on the direction of the price movement, but on many other factors as well. Combining different options on the same underlying asset can bring about almost any form of the payoff function.
This feature of options permits the creation of positions that depend not only on the direction and the amplitude of price fluctuations, but also on many other parameters, including volatility, time left until the expiration, and so forth. The main subject of our consideration is a special type of trading strategies sharing one common property referred to as market-neutrality. With regard to options, market-neutrality means that (1) small changes in the underlying price do not lead to a significant change in the position value, and (2) given larger price movements, the position value changes by approximately the same amount regardless of the direction of the underlying price movement. In reality these rules do not always hold, but they serve as a general guideline for a trader striving for market-neutrality. The main analytical instrument used to create market-neutral positions is delta. The position is market-neutral if the sum of the deltas of all its components (options and underlying assets) is equal to or close to zero. Such positions are referred to as delta-neutral.
Another type of trading strategy that will be considered in this book is a set of market-neutral strategies whose algorithms contain certain directional elements. Although in this case positions are created while taking into consideration the value of delta, its reduction to zero is not an obligatory requirement. Forecasts of the directions of future price movements represent an integral part of such a strategy. These forecasts can be incorporated into the strategy structure in the form of biased probability distributions or asymmetrical option combinations, or by application of technical and fundamental indicators. We will call such strategies partially directional.
Generally, automated strategies are designed to trade one or just a few financial instruments (mainly futures on a given underlying asset). Even if several instruments are traded simultaneously, in most cases positions are opened, closed, and analyzed independently. Options are no exception. Most traders develop systems oriented solely at trading OEX (options on S&P 100 futures) or options on oil futures. In this book we will consider strategies intended to trade an unlimited number of options relating to many underlying assets. All positions created within one trading strategy will be evaluated and analyzed jointly as a whole portfolio.