{"id":4079,"date":"2019-09-06T16:27:55","date_gmt":"2019-09-06T14:27:55","guid":{"rendered":"https:\/\/www.bamboos-consulting.com\/?page_id=4079"},"modified":"2020-09-30T00:37:07","modified_gmt":"2020-09-29T22:37:07","slug":"options-trading-strategies","status":"publish","type":"page","link":"https:\/\/www.bamboos-consulting.com\/options-trading-strategies\/","title":{"rendered":"Options Trading Strategies and Hedging"},"content":{"rendered":"\n<blockquote class=\"wp-block-quote\"><p>Options trading is based on some rational motivation generally involving an edge or the need for hedge. An edge is what determines a trade positive expected value; usually, it is some kind of correct and not widely available information. Instead, a hedge is a trade offsetting an existing risk of another investment. Finally, trading should account for the overall volatility of the profits and losses account.<\/p><\/blockquote>\n\n\n\n<figure class=\"wp-block-embed-youtube wp-block-embed is-type-video is-provider-youtube wp-embed-aspect-16-9 wp-has-aspect-ratio\"><div class=\"wp-block-embed__wrapper\">\n<iframe loading=\"lazy\" title=\"Tom Sosnoff: How I Got Started in Trading\" width=\"640\" height=\"360\" src=\"https:\/\/www.youtube.com\/embed\/videoseries?list=PLIM5RB9CKj9vPq0v9o_T0ecGcXoVP6ddd\" frameborder=\"0\" allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture\" allowfullscreen><\/iframe>\n<\/div><\/figure>\n\n\n\n<h3>Market Making Trading<\/h3>\n\n\n\n<p>MMT attempts at capturing the bid-ask spread and hedging away other sources of risk (i.e., volatility). In general, MMT involves managing the inventory of trades either by adjusting on the basis of the accumulated inventory (minimization to avoid running out of liquidity) or by adjusting on the basis of information (adaptation to the market opinion of prices). As a result, MMT mainly depends on the specific market microstructure (the market structure and the price formation process) of the product rather than on the forecast of its direction or volatility. <\/p>\n\n\n\n<h4>Market Microstructure<\/h4>\n\n\n\n<p>Markets can be of three types:<\/p>\n\n\n\n<ul><li>Order-driven markets (equities, options, etc.) where prices are formed within an <a rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\" href=\"http:\/\/markets.cboe.com\/us\/equities\/market_statistics\/book_viewer\/\" target=\"_blank\">L2 book order<\/a> reporting the traders&#8217; announced orders (market orders and limit orders)<\/li><li>Dealer-driven markets (currencies and other OTC), where the book order is formed by only specialized entities (<a rel=\"noreferrer noopener nofollow\" aria-label=\"market-makers (opens in a new tab)\" href=\"https:\/\/www.sec.gov\/fast-answers\/answersmktmakerhtm.html\" target=\"_blank\">market-makers<\/a> and others) giving quotes that traders must accept or reject <\/li><li>A mix of the two<\/li><\/ul>\n\n\n\n<p>Apart from <a href=\"https:\/\/www.investopedia.com\/terms\/o\/over-the-countermarket.asp\">over-the-counter markets<\/a>, every day an opening <a href=\"http:\/\/markets.cboe.com\/us\/equities\/market_statistics\/auction\/\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">auction process<\/a> consisting of a non-discretionary process finalizes prices before the market opening. However, in some cases (mostly European stock exchanges) an auction market is present at the opening, midday, and closing time consisting of a fully automated demand-supply process aiming at maximizing the transaction volume by setting the price level to the one corresponding to the minimum volume between demand and supply. Note that the transaction volume maximizing price does not have equal supply and demand generally privileging the earlier orders.<\/p>\n\n\n\n<h3>Volatility Trading<\/h3>\n\n\n\n<p>Among all options trading strategies, VT basically attempts to capture the difference between an option\u2019s <a href=\"https:\/\/www.bamboos-consulting.com\/blog\/the-volatility-premium\/\">implied volatility and the realized volatility<\/a> of the underlying; however, to trade only volatility it is generally compulsory to hedge (i.e.,  to remain delta neutral). Indeed, the volatility and the underlying&#8217;s direction are two separate sources of risk; moreover, other sources of risk not included in the strategy must be hedged. In general, long implied volatility trades are profitable if realized is higher (or short implied volatility and realized is lower), at any point in time; however, the closer to expiration, the greater the volatility of P\/L account.<\/p>\n\n\n\n<h3>Expiration Trading<\/h3>\n\n\n\n<p>ET attempts to profit from the premium paid from expiring long options (theoretically valued very close to zero). ET is based on a specific anomaly named pinning happening whenever an underlying settles at expiration within 10 cents of its strike more often than what could be expected. In other terms, the pinning effect subsumes some process causing the underlying to be towed toward the strike price; specifically, research has documented the presence of pinning only in underlying with options as a consequence of market makers&#8217; gamma hedging. Indeed, when the market incorporates the information about which strike the underlying will settle, implied volatility will collapse, options will be sold, and increasing gamma will be hedged (by dynamic hedgers). As a result, the pinning effect will be more marked whenever consistent open interest is present in the options market in strikes near the underlying price. Thus, the pinning effect can be characterized as follows:<\/p>\n\n\n\n<ul><li>consistent open interest in options (best with very high underlying price)<\/li><li>delta hedging traders long at the money options<\/li><li>the underlying is often subject to directional speculation<\/li><li>on expiration days the underlying experiences a disproportionately large amount of small returns (suggesting pinnable strikes the ones the underlying closed near on Thursday evening)<\/li><\/ul>\n\n\n\n<p>ET requires to manage different sources of risk:<\/p>\n\n\n\n<ul><li>Forward risk arising from in the money cash-settled options. With such options the hedge is not made with the underlying; thus, we need to manage to close this position (usually a future).<\/li><\/ul>\n\n\n\n<ul><li>Exercising risk may arise with options not automatically exercised (DAX, FTSE, etc.) at expiration whenever not only at the money positions are closed.<\/li><\/ul>\n\n\n\n<h3>Hedging<\/h3>\n\n\n\n<p>Hedging is a compulsory step independently of the options trading strategy selected. In practice, hedging is not a continuous process but in its simplest static incarnation it is performed with respect to some threshold:<\/p>\n\n\n\n<ul><li>at predefined regular time intervals<\/li><li>whenever a predefined delta range is violated<\/li><li>whenever a predefined underlying price range is violated<\/li><li>based on a utility function quantifying the risk aversion  <\/li><\/ul>\n\n\n\n<p>However, hedging should be considered a dynamic process to account for the gamma of the option position. Note that the closer to expiration, the less information is conveyed by<a href=\"https:\/\/www.bamboos-consulting.com\/blog\/a-primer-on-option-pricing\/\"> the Greeks as risk measures<\/a>: Vega and rho are about zero, whereas gamma and theta may assume strange figures for at the money options. Indeed, near expiration hedging is the most affecting factor. As a result, hedging may affect the profitability of the trades:<\/p>\n\n\n\n<ul><li>Hedging a long position where we are crossing a strike will dampen volatility<\/li><li>Hedging a short position where we are rapidly crossing a strike will increase volatility<\/li><li>Hedging a short position where we are slowly settling to a strike will not impact the market as it simply involves waiting and hoping<\/li><\/ul>\n\n\n\n<p>Finally, the pinning effect determines a source of risk for any trade having the underlying settling close to an option\u2019s strike value at expiration for which a short position is open; indeed, it is impossible to predict whether the option will be exercised or not.<\/p>\n\n\n\n<p><\/p>\n\n\n\n<p><strong>References<\/strong><\/p>\n\n\n\n<p>Sinclair, E. (2016). Options Trading Strategies<\/p>\n\n\n\n<p>Sebastian, M. (2016). Trading options for hedge<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Options trading is based on some rational motivation generally involving an edge or the need for hedge. An edge is what determines a trade positive expected value; usually, it is some kind of correct and not widely available information. Instead, a hedge is a trade offsetting an existing risk of another investment. Finally, trading should&hellip;<\/p>\n<p class=\"read-more\"><a class=\"readmore-btn\" href=\"https:\/\/www.bamboos-consulting.com\/options-trading-strategies\/\">Read More<span class=\"screen-reader-text\">  Read More<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"parent":0,"menu_order":0,"comment_status":"closed","ping_status":"closed","template":"page-options.php","meta":{"_seopress_robots_primary_cat":""},"categories":[5,3,130,78],"tags":[147,142,145,146],"amp_enabled":false,"_links":{"self":[{"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/pages\/4079"}],"collection":[{"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/pages"}],"about":[{"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/types\/page"}],"author":[{"embeddable":true,"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/comments?post=4079"}],"version-history":[{"count":0,"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/pages\/4079\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/media?parent=4079"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/categories?post=4079"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.bamboos-consulting.com\/wp-json\/wp\/v2\/tags?post=4079"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}