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A Few Notes on Day Trading Options

| | Posted in: Equity Options

In his 2009 book Day Trading Options: Profiting from Price Distortions in Very Brief Time Frames, author Jeff Augen argues that individual investors operate at material informational and analytical disadvantages whether focusing on fundamentals or trend-based technical indicators. He has written this book”for investors who are seeking a different approach and are willing to work very hard to perfect new trading strategies.” This different approach seeks to exploit “well-characterized pricing anomalies and distortions… [that] exist, in part, because contemporary option pricing models assume continuous trading… Today’s option market [responds to market down time] by varying the implied volatility priced into option contracts [thereby presenting a] profit opportunity [that] can become very large under certain circumstances.” Also, “news events often introduce brief distortions that take many minutes for the market to digest. During these brief time frames the market becomes inefficient…[as detected by] a new technical indicator that can be used to quantify rising or falling volatility.” Some notable points from the book are:

From Chapter 1, “Basic Concepts”:

Page 5: “…options day trading focuses only on the underlying mathematics. It does not rely on any financial predictions, company results, or market direction.”

Pages 32-33: “A…realistic approach is to take advantage of occasional pricing inefficiencies that arise in the options market. These distortions can be related to earnings announcements, expiration week, weekend time decay, intraday implied volatility swings, differences between overnight and intraday volatility, or news and rumors. …Private investors can learn to capitalize on such distortions to generate very large returns with relatively little risk. They can also leverage the advances that have been achieved in trading platforms to capture as much profit as possible from efficient execution. Combined with narrow bid-ask spreads and high levels of liquidity, these advances have created unprecedented opportunities for private investors who want to exploit the technical advantages and financial leverage of options while trading in the time frame of a single day.”

From Chapter 2, “New Directions in Automated Trading”:

Pages 77-78: “…the combined efforts of institutional traders equipped with supercomputing platforms and millions of sophisticated private investors with real-time access to financial markets and news has created a situation where inefficiencies are extinguished almost immediately. As a result, it has become nearly impossible to find a combination of pricing parameters or chart patterns that can be profitably exploited for any length of time. …Many of these problems are disguised by back testing systems that allow traders to overoptimize a set of technical indicators and rules.”

From Chapter 3, “Trading Volatility Distortions”:

Pages 81: “Overnight (close-to-open), intraday (open-to-close), and traditional (close-to-close) measures of volatility can vary dramatically. These differences can be used to identify mispriced options and structure statistically advantaged trades. Volatility distortions sometimes vary by weekday. These calendar effects can help time entry and exit points for certain types of short-term trades.”

Page 89: “The principal goal of an option trader is to arbitrage subtle differences between implied and fair volatility by structuring positions that capitalize on those differences.”

Page 97: “Options are…underpriced during the day and overpriced when the market is closed.”

Pages 105-106: “For the overall market, across all days, the average 24-hour price change is only 1.2 times as large as the average 6.5-hour intraday change. Of all the distortions in the options market, this is clearly the largest. …the most sensible approach is to structure positions early in the day and hold them until they are profitable or the market closes. The goal is to avoid owning dramatically overpriced options during the long overnight time frame when time decay dominates and volatility is diminished.”

Pages 108-109: “Our goal is to structure strangles with underpriced options on stocks that tend to exhibit higher volatility than the amount priced into our trade. This goal is best accomplished by selecting stocks with very high intraday to overnight volatility ratios and avoiding long-term trades in which time decay begins to dominate. Especially damaging are trades that span weekends…the most destructive being the final weekend before options expiration.”

Page 117: “Ratio backspreads (reverse ratios) composed of short options at a near strike and a larger quantity of long options at a far strike represent another excellent alternative.”

From Chapter 4, “Working with Intraday Price Spike Charts”:

Page 131: “…the volatility of a series of price changes over very brief time frames of just a few minutes…can be used as entry points for certain types of trades, or as triggers for legging into multipart trades. They can also be useful for timing exit points for existing positions.”

Page 132: “The frequency and magnitude of large price changes in very brief time frames is much larger than option pricing theory predicts. These large spikes present unique opportunities to option traders because they are not comprehended in the [option] price.”

Pages 133-134: “The principal goal of an option trader is to arbitrage subtle differences between implied and fair volatility by structuring positions that capitalize on those discrepancies. In that regard, trading options is equivalent to buying and selling standard deviations. …rising levels of instability often mark the end of a brief but sharp uptrend. This instability can be visualized as increasingly large up and down price spikes. Sometimes they take the form of a single pair of spikes in opposite directions. Conversely, a sharp consistently downward trend often ends with successively smaller downward price spikes followed by a significant upward spike.”

Page 156: “Price-change behavior can be studied using histogram charts that recast changes in standard deviations measured against a moving window of fixed length. The resulting charts can be used to identify rising and falling volatility and make predictions based on the price stability of the underlying security. These predictions can often be used to identify the end of a trend or to predict that a stock is becoming unstable. Traders can use this information to select entry and exit points for complete trades or parts of trades.”

From Chapter 5, “Special Events”:

Page 157: “The relative magnitude of [option pricing] distortions increases sharply as expiration approaches. The market efficiently responds to these distortions by depressing and inflating option prices in predictable ways. These changes can be used as the basis for highly profitable trades. News events often create brief inefficiencies as the market absorbs and responds to new information. These inefficiencies represent outstanding trading opportunities that sometimes persist for several hours.”

Page 167: “…a pricing distortion related to a long weekend just prior to expiration week…represents a market efficiency rather than an inefficiency because it involves discounting of prices to accommodate excessive, but inevitable, time decay. The market accommodation essentially packs three days of time at the end of the expiration cycle into a single 6.5-hour trading day. [Also,] opportunity arises as the market briefly becomes inefficient while digesting [a large amount of new information].”

Some cautions regarding return expectations for the trading methods described in the book are:

  • While implying that returns from the described trading methods are very high and consistent, the book offers no model of portfolio-level return statistics that a trader could reasonably expect to experience over a long period.
  • The analyses and examples in the book focus on very recent data (mostly mid-2008 through mid-2009), a high-volatility regime. This recency is cogent for assessing an environment characterized by current levels of algorithmic trading and trading frictions, but results for other market regimes may differ.
  • The author does not explain why the market does not adapt to option pricing inefficiencies derived from market down time. Why would counterparties persist in losing money to the suggested trading methods?
  • The book is silent on the number of alternatives the author considered in isolating targeted anomalies, devising strategies to exploit the anomalies and selecting strategy parameters to optimize exploitation. To the extent that the author considered alternatives, data snooping bias would be incorporated into the results presented.
  • The author relies on mean and standard deviation statistics in assessing risk-adjusted trade profitability and in indicator construction. To the extent that asset returns do not have normal distributions, “normal” interpretations of these statistics may mislead.

In summary, traders may find Day Trading Options an interesting exploration of potential short-term options pricing inefficiencies and of approaches to exploiting such anomalies. However, the book presents no associated model of reasonably sustainable portfolio-level returns.

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