Introduction to Automated Option Trading: Create, Optimize, and Test Automated Trading Systems
This chapter is from the book
This chapter is from the book
This chapter is from the book
This book presents a concept of developing an automated system tailored specifically for options trading. It was written to provide a framework for transforming investment ideas into properly defined and formalized algorithms allowing consistent and disciplined realization of testable trading strategies.
Extensive literature has been published in the past decades regarding systematic, algorithmic, automated, and mechanical trading. In the Bibliography of this book, we list some of the comprehensive works that deserve special attention. However, all books dedicated to the creation of automated trading systems deal with traditional investment tools, such as stocks, futures, or currencies. Although the development of options-oriented systems requires accounting for numerous specific features peculiar to these instruments, automated trading of options remains beyond the scope of professional literature. The philosophy, logic, and quantitative procedures used in the creation of automated systems for options trading are completely different from those used in conventional trading algorithms. In fact, all the components of a system intended for automated trading of options (strategy development, optimization, capital allocation, risk management, backtesting, performance measurement) differ significantly from their analogs in the systems intended for trading of plain assets. This book describes consecutively the key stages of creating automated systems intended specifically for options trading.
Automated trading of options represents a continuous process of valuation, structuring, and long-term management of investment portfolios (rather than individual instruments). Due to the nonlinearity of options, the expected returns and risks of their complex portfolios cannot be estimated by simple summation of characteristics corresponding to individual options. Special approaches are required to evaluate portfolios containing options (and their combinations) related to different underlying assets. In this book we discuss such approaches, describe systematically the core properties of option portfolios, and consider the specific features of automated options trading at the portfolio level.
The Book Structure
An automated trading system represents a package of software modules performing the functions of developing, formalizing, setting up, and testing trading strategies.
Chapter 1, “Development of Trading Strategies,” discusses the development and formalization of option strategies. Since there is a huge multitude of trading strategies somehow related to options, we limit our discussion to market-neutral strategies. The reason for selecting this particular type of option strategies relates to its wide popularity among private and institutional investors.
Strategy setup includes optimization of its parameters, capital allocation between portfolio elements, and risk management. Chapter 2, “Optimization,” deals with various optimization aspects. In this chapter we discuss various properties of optimization spaces, different types of objective functions and their interrelationships, several methods of multicriteria optimization, and problems of optimization steadiness relative to small changes in the parameters and strategy structure. Special attention is given to the application of traditional methods of parametric optimization to complex option portfolios.
In Chapter 3, “Risk Management,” we discuss a set of option-specific risk indicators that can be used for developing a multicriteria risk management system. We investigate the influence of different factors on the effectiveness of the risk indicator and on the number of indicators needed for effective risk measuring.
In Chapter 4, “Capital Allocation and Portfolio Construction,” we consider various aspects of capital allocation among the elements of an option portfolio. Capital can be allocated on the basis of different indicators not necessarily expressing return and risk. This chapter describes the step-by-step process of constructing a complex portfolio out of separate option combinations.
The testing of option strategies using historical data is discussed in Chapter 5, “Backtesting of Option Trading Strategies.” In this chapter we stress the particularities of creating and maintaining option databases and provide methods to verify data accuracy and reliability. The problem of overfitting and the main approaches to solving it are also discussed. Performance evaluation of option strategies is also the topic of this chapter.