Option pricing underlying volatility trading strategies and techniques
A synthetic position is essentially a position that recreates the characteristics of another trading position by using different financial instruments such as an options position that has the same characteristics as holding stock. Strategies that use a combination of options and stock to emulate other trading strategies are said to be synthetic.
They are typically used to adjust an existing strategy when the outlook changes without having to make too many additional transactions. The three most commonly used ones are the synthetic straddle, the synthetic short straddle, and the synthetic covered call. For more information on these please click here. Protective puts and protective calls are trading strategies that use options to protect existing profits that have been made, but not realized, from either buying or short selling stock.
The basic principle is that, when a long stock position or a short stock position has performed well, a trader can use a protective put or a protective call respectively to preserve the profits that already have been made in the event of a reversal, but also allow continued profitability should the stock continue to move in the right direction. If you wanted to be able to profit from further price increases, but also safeguard against the price dropping back down, then the protective put will help you do this.
It's essentially a straightforward hedging technique. For more information on protective puts and protective calls, please visit this page. Delta is one of the five main Greeks that influence the price of options. It's in fact widely considered the most important of these, because it's a measure of how much the price of an option will change based on the price movements of the underlying security.
Delta neutral strategies are used to create positions where the delta value is zero, or close to it. Such positions aren't affected by small price movements in the underlying security, meaning there's little directional risk involved. They are typically used to hedge existing positions or to try and profit from time decay or volatility.
Please click here for more detailed information on how these strategies can be used. Gamma neutral strategies are designed to create trading positions where the gamma value is zero or very close to zero; which would mean that the delta value of those positions should remain stable regardless of what happens to the price of the underlying security. They can be used for a number of purposes, such as reducing the volatility of a position or attempting to profit from changes in implied volatility.
They can also be combined with delta neutral strategies for more stable hedging. You find out more information on them here. Stock replacement is an investment technique that aims to closely match the potential returns of holding stocks by using a different financial instrument, or combination of financial instruments.
It's typically used for one or more of a number of reasons that include reducing the amount of capital required, increasing the potential profits, limiting losses, and freeing up extra funds that can be used for hedging purposes.
One of the most commonly used stock replacement strategies involves buying calls instead of buying stock, and this has a number of advantages. It's actually a very simple strategy, and even complete beginners should have no problem using it. More advanced traders can also use hedging techniques to further limit the risks and volatility that are involved. You can read about using options for stock replacement here.
Although sometimes it's best to simply cut your losses and exit a losing position, equally there will be occasions when there are alternatives that may be worth considering.
Stock repair is a technique that stock traders can employ, using options, to increase the chances of recovering from being long on a stock that has fallen in price. When used correctly, it's possible to break even from a smaller price increase in the stock than would otherwise be possible, without having to commit any more capital.
Although this sounds like it might be quite hard to do, in reality stock repair using options is actually quite simple. To find out more about how and when to use this technique, please visit this page. Delta-hedged options are priced using traditional models such as Black-Scholes and stochastic volatility to eliminate any arbitrage gains.
The central question is whether a relationship exists between delta-hedged option gains and well-known stock characteristics used by financial analysts and investors. Of the 12 characteristics studied by the research team, eight of them, namely market capitalisation, cash-to-asset ratio, return on equity, new issuance, idiosyncratic volatility, monthly returns, annual returns and the dispersion of analyst forecast, show a strong correlation with delta-hedged option returns.
That means long-short trading strategies involving delta-hedged options based on those eight stock characteristics can yield stable, predictable profits over time.
Their Sharpe ratios — a commonly used measure of risk-adjusted return — ranged from 0. Treasury bills has a Sharpe ratio of exactly zero. The correlation remains robust regardless of seasonality and market conditions. For instance, the profitability of the option trading strategies did not diminish during the subprime mortgage crisis. The predictive power of these stock fundamentals suggests one of two things: While further studies are necessary to understand the exact cause of the abnormal returns, Prof.
More specifically, trading frictions created by regulatory limits to arbitrage may have played a key role in, ironically, spawning the delta-hedged arbitrage. Until this anomaly is corrected, arbitrage opportunities continue to exist and risk-free profits in the option market — the proverbial free lunch — are there for the taking.
More recently, in May this year, Prof. Cao presented his research at the 4th annual Asia Bureau of Finance and Economic Research Conference in Singapore, one of the largest events of its kind in Asia Pacific. In June, he presented it at Macquarie Global Quantitative Research Conference, a leading conference for finance industry, and in August, at European Finance Association Annual Meeting in Oslo, Norway, a leading conference for finance academic researchers.
Reactions from the financial community have ranged from excitement and intrigue to amazement and disbelief. To answer the sceptics, Prof. So far, the findings have held up and the research remains on firm ground. There have also been questions of a more pragmatic nature: When it comes to risk-free gains, however, popularity can be a double-edged sword.
It may eventually disappear.