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2 Part Question -1) please poke holes in this strategy 2) how do you search for long/short pairs?

I started working on 2 new algos, but I wanted to ask what are some of the issues w/this strategy before I dive head first. I'm new to options / hedging, so please if I sound like a complete turd, please be gentle (don't flush just yet! ;P) I'm still not too familiar with how options work so i may sound foolish (i might be just re-iterating some well known trading strategy)

1) hedge longs w/put options (and vice versa, shorts w/call options).

As such, I am seeking volatility, so I would look for high beta stocks. I would look for (reverse directional) option either in that stock, or in some other correlated asset like SPY / QQQ. If directional bet is correct by the time of option expiration, let option expire and close out the directional bet. If not, close out both positions.

I got to thinking.. why even bother buying stocks? Might as well just go options in both directions. But I guess something about this just seems.. unsound. But I'd love to hear why.

2) other than brute force, how do you look for pairs that are candidates for long/short strategy?

My initial understanding was that you are looking for some inherent relationship between the two.. such as

  • competitors of same sector
  • buyer / supplier
  • connected via insider
  • (Some other unknown method?)

which can be all mined via entity relationship extraction.

And even if you do determine this relationship, how would you determine that the relationship would actually be forward looking? (i.e predictive)

3) Are there other hedging mechanisms that I'm not aware of?

Ok I lied.. so 3 part question.

6 responses

1) We don't get a lot of options questions here on Quantopian, but I traded them on the side 20 years ago. Buying matching put/calls is called a straddle.

2) We have a lot of resources here on Quantopian to help you learn about pairs! Check out our lectures, particularly Intro to Pairs Trading, the subsequent examples, and this neat visualization.

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Hi, i trade a small personal account in a way very different from what i'm doing here on Quantopian. US equities, just simple long-only positions and I don't hedge with options. I tried doing that but gave up. I will explain why in a moment. I also trade options on US stocks, just simple Long (i.e. BTO & STC) Call strategies to play the up-moves, or Long Put strategies for the down-moves. I tried spreads & straddles but quickly gave that up too.

The biggest problem with options trading compared to stocks relates to the size of the bid-ask spread on all but the most highly liquid options on the most heavily traded stocks. Where bid-ask is generally small as a % of the stock price for most stocks, for options it is often huge, so much in fact (e.g can be > 50% of the mid-point price) that trading in & out of anything but the most liquid options just ends up making a lot of money for the broker / market-maker and not much left for you the trader.

So the answer to 1) is the size of the bid-ask which you have to pay as a frictional cost on all transactions, and on most options it is horrible.
Options always look like they should be great trading vehicles (if you don't over-trade compared to the size of your account) because of the leverage and the "no downside risk compared to futures" because "...with options the most you can lose is 100%". That's the sales pitch one hears but unfortunately 100% is about the amount most small retail account option buyers do end up losing.Unless you select your options series very carefully in terms of Strike & Expiry and ensure high volume and OI in the selected series, then usually the large bid-ask (as a % of price, as compared to equities) is what ends up eating you.

And then of course there is the decaying time premium effect. It's disheartening if you are Long Call options and watching while the underlying is going up in price, but just not fast enough to offset the time decay effect, and so your option position is losing, whereas a stock or futures position would have been winning. That's why, to the best of my knowledge, most amateurs are option buyers attracted by the leverage, while most professionals are option writers who understand which side the probabilities favor.

As Tony points out, there's a lot that goes into selecting the right option....and what you have to give up in the bid -ask spread
is just the beginning. You have to have a pretty good handle on when you think the assets in your strategy will be unwind in terms of
picking the right expiry. Next you need to choose the right strike price (delta), and probability that that option will perform (gamma).
You can be right with direction...and still lose money with the option because the move was too slow....you overpaid for the option...
or you picked the wrong expiry and were eaten up with decay.

Read "Options as a Strategic Investment " by McMillan...to get a handle on all the Greeks (delta,gamma,theta,vega, etc)

An important thing to know right off the bat is that options are wasting assets that decay over time....which is why net sellers of
calls and puts do better over time than buyers except during huge fast moves in the underlying

If you are confident enough you can sell puts to replicate long stock A and sell calls to replicate short stock B.....there are scenarios where
you can be wrong as still make money. The most conservative play is Buy actual stock A and buy puts in Stock B

good luck,mitch

Completely agree with all Mitch's comments above.
The book he recommends is one of the best but, IMHO, even if you read and understand all of it, there is still a HUGE amount to learn before you can even hope to be successful with options. In addition to all the standard "Greeks" of options that everyone writes about, actually I found the most important one to be lambda, which no-one ever writes about. Option lambda, unlike delta, gives you the % change in option value as a function of % change in underlying and this is really what you need to consider when looking at option costs & potential profits in relation to the width of the bid-ask. I wrote myself a little program to do this which used an empirical relationship I found between width of bid-ask in % vs liquidity of the underlying. What I then found, to my surprise, was that in practice MOST options tend to have a bid-ask that is sufficiently wide to ensure that, for most price moves on the underlying, the probability that you (rather than the market-maker / option writer) will actually make money on the option play tends to zero. I use it as a filter to see if I can find ANY option series where I actually have a chance. Occasionally there is, but it is almost always only in the large, highly liquid stocks with highly liquid options with large OI. As Mitch says, good luck ..... because you will need it! Honestly I think there are easier ways to make money than trading by going Long options.

Thanks Mitch and Tony. You guys definitely shed light on my options darkness.

@Tony: Honestly I think there are easier ways to make money than trading by going Long options.

Can you share what this is? Or at least hints..

Sure, no secrets at all with this. Quantopian is a great platform and gives you the ability to develop & test out all sorts of different strategies with equities and with futures. It's not too hard to come up with various different ideas that will work for equities. Maybe not brilliant ones, but at least workable ones. Then examine these very carefully and try to continually refine & improve them. I'm sure lots of people here at Quantopian will be happy to help you. Equities and/or futures strategies are a good way to go. Options however are an order of magnitude more complicated than futures & equities. Quantopian does not support options. Most people who trade options (except the market-makers) lose. Generally the people who make money on options are the people who write the options. If you want to do this, then you need to do it in a different context outside of Quantopian. Even though I know that the best way to make money with options is to write them (i.e. as a seller rather than as a buyer), I don't do that either because personally I don't like the skew of the risk-return profile from writing options (i.e. lots of small "almost sure wins" and then a big loss if things go wrong). So use Quantopian and just work on strategies with equities & futures. A great place to start is the Quantopian lessons & tutorials and then build up from there.