Nonlinear Trading Strategies

I own got long been partial to linear strategies due to their simplicity as well as relative immunity to overfitting. They tin move used quite easily to turn a profit from mean-reversion. However, at that topographic point is a serious problem: they are quite fragile, i.e. vulnerable to tail risks. As nosotros motility from mean-reverting strategies to momentum strategies, nosotros straight off innovate a nonlinearity (stop losses), simply simultaneously remove certain tail risks (except during times when markets are closed). But if nosotros desire to relish anti-fragility as well as are going to innovate nonlinearities anyway, nosotros mightiness also acquire full-monty, as well as reckon options strategies. (It is no surprise that Taleb was an options trader.)

It is slowly to encounter that options strategies are nonlinear, since options reward curves (value of an option as part of underlying stock price) are apparently nonlinear. I personally own got resisted trading them because they all look as well as so complicated, as well as I detest complexities. But lately a reader recommended a picayune mass to me: Jeff Augen's "Day Trading Options" where the Black-Scholes equation (and indeed whatever equation) is mercifully absent from the entire treatise. At the same time, it is suffused alongside qualitative ideas. Among the juicy bits:

1) We tin discovery distortions inward the 2D implied volatility surface (implied volatility equally z-axis, expiration months equally x, as well as nail prices equally y) which may hateful revert to "smoothness", thus presenting arbitrage opportunities. These distortions are introduce for both stock as well as stock index options.

2) Options are underpriced intraday as well as overpriced overnight: thus it is oft a proficient sentiment to purchase them at the marketplace seat opened upwardly as well as sell them at marketplace seat closed (except on roughly exceptional days! See iv below.). In fact, at that topographic point are certainly days of the calendar week where this distortion is the nearly drastic as well as thus favorable to this strategy.

3) Certain cash instruments own got unusually high kurtosis, simply their corresponding selection prices consistently underprice such tail risks. Thus structures such equally strangles or backspreads tin oft move profitable without incurring whatever left tail risks.

4) If at that topographic point is a long weekend earlier expiration solar daytime (e.g. Easter weekend),  the fourth dimension decay of the options value over three days is compressed into an intraday decline on the final trading solar daytime earlier the weekend.

Now, equally quantitative traders, nosotros own got no require to accept his give-and-take on whatever of these assertions. So, onward to backtesting!

(For those who may move stymied yesteryear the lack of affordable historical intraday options data, I recommend Nanex.net.)

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There are even as well as so two slots available inward my online Mean Reversion Strategies workshop inward May. The workshop volition move conducted live via Adobe Connect, and is express to a sum of iv participants. Part of the workshop volition focus on how to avoid getting wound when a couple or a portfolio of instruments halt cointegrating.