Automated option trading : create, optimize, and test automated trading systems

The first and only book of its kind, Automated Options Trading describes a comprehensive, step-by-step process for creating automated options trading systems. Using the authors' techniques, sophisticated traders can create powerful frameworks for the consistent, disciplined realization of well-defined, formalized, and carefully-tested trading strategies based on their specific requirements. Unlike other books on automated trading, this book focuses specifically on the unique requirements of options, reflecting philosophy, logic, quantitative tools, and valuation procedures that are completely different from those used in conventional automated trading algorithms. Every facet of the authors' approach is optimized for options, including strategy development and optimization; capital allocation; risk management; performance measurement; back-testing and walk-forward analysis; and trade execution. The authors' system reflects a continuous process of valuation, structuring and long-term management of investment portfolios (not just individual instruments), introducing systematic approaches for handling portfolios containing option combinations related to different underlying assets. With these techniques, it is finally possible to effectively automate options trading at the portfolio level. This book will be an indispensable resource for serious options traders working individually, in hedge funds, or in other institutions.

Author Notes

Sergey Izraylevich , Ph.D., Chairman of the Board of High Technology Invest Inc., has traded options for well over a decade and currently creates automated systems for algorithmic option trading. A Futures magazine columnist, he has authored numerous articles for highly rated, peer-reviewed scientific journals. He began his career as a lecturer at The Hebrew University of Jerusalem and Tel-Hay Academic College, receiving numerous awards for academic excellence, including Golda Meir's Prize and the Max Shlomiok honor award of distinction.

Vadim Tsudikman , President of High Technology Invest Inc., is a financial consultant and investment advisor specializing in derivatives valuation, hedging, and capital allocation in extreme market environments. With more than 15 years of option trading experience, he develops complex trading systems based on multicriteria analysis and genetic optimization algorithms.

Izraylevich and Tsudikman coauthored Systematic Options Trading (FT Press) and regularly coauthor Futures magazine articles on cutting-edge issues related to option pricing, volatility, and risk management.

Introduction	p. xv
Chapter 1 Development of Trading Strategies	p. 1
1.1 Distinctive Features of Option Trading Strategies	p. 1
1.1.1 Nonlinearity and Options Evaluation	p. 1
1.1.2 Limited Period of Options Life	p. 2
1.1.3 Diversity of Options	p. 3
1.2 Market-Neutral Option Trading Strategies	p. 4
1.2.1 Basic Market-Neutral Strategy	p. 4
1.2.2 Points and Boundaries of Delta-Neutrality	p. 6
1.2.3 Analysis of Delta-Neutrality Boundaries	p. 10
1.2.4 Quantitative Characteristics of Delta-Neutrality Boundaries	p. 14
1.2.5 Analysis of the Portfolio Structure	p. 21
1.3 Partially Directional Strategies	p. 34
1.3.1 Specific Features of Partially Directional Strategies	p. 35
1.3.2 Embedding the Forecast into the Strategy Structure	p. 36
1.3.3 The Call-to-Put Ratio at the Portfolio Level	p. 40
1.3.4 Basic Partially Directional Strategy	p. 42
1.3.5 Factors Influencing the Call-to-Put Ratio in an Options Portfolio	p. 44
1.3.6 The Concept of Delta-Neutrality as Applied to a Partially Directional Strategy	p. 49
1.3.7 Analysis of the Portfolio Structure	p. 57
1.4 Delta-Neutral Portfolio as a Basis for the Option Trading Strategy	p. 61
1.4.1 Structure and Properties of Portfolios Situated at Delta-Neutrality Boundaries	p. 62
1.4.2 Selection of an Optimal Delta-Neutral Portfolio p. 67
Chapter 2 Optimization	p. 73
2.1 General Overview	p. 73
2.1.1 Parametric Optimization	p. 73
2.1.2 Optimization Space	p. 75
2.1.3 Objective Function	p. 78
2.2 Optimization Space of the Delta-Neutral Strategy	p. 79
2.2.1 Dimensionality of Optimization	p. 80
2.2.2 Acceptable Range of Parameter Values	p. 85
2.2.3 Optimization Step	p. 87
2.3 Objective Functions and Their Application	p. 88
2.3.1 Optimization Spaces of Different Objective Functions	p. 89
2.3.2 Interrelationships of Objective Functions	p. 91
2.4 Multicriteria Optimization	p. 96
2.4.1 Convolution	p. 97
2.4.2 Optimization Using the Pareto Method	p. 99
2.5 Selection of the Optimal Solution on the Basis of Robustness	p. 102
2.5.1 Averaging the Adjacent Cells	p. 103
2.5.2 Ratio of Mean to Standard Error	p. 104
2.5.3 Surface Geometry	p. 106
2.6 Steadiness of Optimization Space	p. 108
2.6.1 Steadiness Relative to Fixed Parameters	p. 109
2.6.2 Steadiness Relative to Structural Changes	p. 110
2.6.3 Steadiness Relative to the Optimization Period	p. 112
2.7 Optimization Methods	p. 114
2.7.1 A Review of the Key Direct Search Methods	p. 116
2.7.2 Comparison of the Effectiveness of Direct Search Methods	p. 127
2.7.3 Random Search	p. 131
2.8 Establishing the Optimization Framework: Challenges and Compromises	p. 134
Chapter 3 Risk Management	p. 135
3.1 Payoff Function and Specifics of Risk Evaluation	p. 135
3.1.1 Linear Financial Instruments	p. 136
3.1.2 Options as Nonlinear Financial Instruments	p. 138
3.2 Risk Indicators	p. 139
3.2.1 Value at Risk (VaR)	p. 140
3.2.2 Index Delta	p. 141
3.2.3 Asymmetry Coefficient	p. 157
3.2.4 Loss Probability	p. 159
3.3 Interrelationships Between Risk Indicators	p. 161
3.3.1 Method for Testing the Interrelationships	p. 161
3.3.2 Correlation Analysis	p. 162
3.4 Establishing the Risk Management System: Challenges and Compromises	p. 165
Chapter 4 Capital Allocation and Portfolio Construction	p. 167
4.1 Classical Portfolio Theory and Its Applicability to Options	p. 167
4.1.1 Classical Approach to Portfolio Construction	p. 168
4.1.2 Specific Features of Option Portfolios	p. 169
4.2 Principles of Option Portfolio Construction	p. 170
4.2.1 Dimensionality of the Evaluation System	p. 170
4.2.2 Evaluation Level	p. 173
4.3 Indicators Used for Capital Allocation	p. 174
4.3.1 Indicators Unrelated to Return and Risk Evaluation	p. 174
4.3.2 Indicators Related to Return and Risk Evaluation	p. 178
4.4 One-Dimensional System of Capital Allocation	p. 183
4.4.1 Factors Influencing Capital Allocation	p. 183
4.4.2 Measuring the Capital Concentration in the Portfolio	p. 192
4.4.3 Transformation of the Weight Function	p. 196
4.5 Multidimensional Capital Allocation System	p. 204
4.5.1 Method of Multidimensional Systetn Application	p. 204
4.5.2 Comparison of Multidimensional and One-Dimensional Systems	p. 206
4.6 Portfolio System of Capital Allocation	p. 209
4.6.1 Specific Features of the Portfolio System	p. 209
4.6.2 Comparison of Portfolio and Elemental Systems	p. 211
4.1 Establishing the Capital Allocation System: Challenges and Compromise	p. 214
Chapter 5 Backtesting of Option Trading Strategies	p. 217
5.1 Database	p. 217
5.1.1 Data Vendors	p. 218
5.1.2 Database Structure	p. 219
5.1.3 Data Access	p. 220
5.1.4 Recurrent Calculations	p. 221
5.1.5 Checking Data Reliability and Validity	p. 222
5.2 Position Opening and Closing Signals	p. 225
5.2.1 Signals Generation Principles	p. 225
5.2.2 Development and Evaluation of Functionals	p. 226
5.2.3 Filtration of Signals	p. 227
5.3 Modeling of Order Execution	p. 228
5.3.1 Volume Modeling	p. 229
5.3.2 Price Modeling	p. 230
5.3.3 Commissions	p. 231
5.4 Backtesting Framework	p. 232
5.4.1 In-Sample Optimization and Out-of-Sample Testing	p. 232
5.4.2 Adaptive Optimization	p. 233
5.4.3 Overfitting Problem	p. 234
5.5 Evaluation of Performance	p. 236
5.5.1 Single Event and Unit of Time Frame	p. 236
5.5.2 Review of Strategy Performance Indicators	p. 237
5.5.3 The Example of Option Strategy Backtesting	p. 242
5.6 Establishing the Backtesting System: Challenges and Compromises	p. 246
Bibliography	p. 247
Appendix	p. 251
Basic Notions	p. 251
Payoff Functions	p. 254
Separate Options	p. 254
Option Combinations	p. 255
Index	p. 261

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Table of Contents