November 30, 2010 06:00 PM

Systematic Option Trading: Evaluating, Analyzing, and Profiting from Mispriced Option Opportunities
By: Sergey Izraylevich and Vadim Tsudikman
FT Press
\$79.99; 288 pages

If you have a fairly powerful personal computer with access to a stream of market data, this book should enhance your trading experience with not too much effort. Although the authors warn in their introduction that the reader should have familiarity with probability theory and statistics in order to “delve deeply into proofs and arguments,” for the most part the math is explained clearly and is tied directly to example calculations and charts.

The authors have contributed several articles on their book’s topics to Futures magazine. These provide an additional introduction to the primary systematic method described more completely in the book – the concept of multi-criteria analysis, or MCA. The foundation for the systematic approach is shown to be consecutive execution of several procedures – valuation, comparative analysis and selection of option combinations. The overall objective of the strategies and analysis is improved speculative profits from option trading.

The book’s first four chapters deal with the definitions and various aspects of criteria. A criterion is defined as “any numerical indicator suitable for evaluation and comparison of individual options and their combinations.” Criteria are “unique combinations of computational algorithms and mathematical functions” and are the main instruments of evaluation.

In testing criteria effectiveness, correlation between criteria values and realized profit shows that the value of the correlation coefficient is usually small and variable, even when the predictive value of the criterion is known in advance. In response, the authors use a transformation in data – combinations of two and four data days – to mute the influence of external factors and to demonstrate the underlying strong correlation between criteria and profit.

Several conclusions following the tests of effectiveness are interesting: (1) Some criteria are effective regardless of the strategies they are used for – for example, expected profit and profit probability; (2) Certain criteria may be highly effective when applied to some strategies but are ineffective for others – for example, expected profit based on empirical distribution, and (3) Some criteria may show the highest effectiveness when selecting combinations for a certain strategy but become the worst when applied to the opposite strategy.

Later chapters are concerned with selection of option strategies and underlying assets. Strategies compared by pairs in an example selection technique include long straddle & short straddle, long straddle & long calendar spread, short straddle & short calendar spread and long calendar spread & short calendar spread.

Other chapters cover basic concepts of multicriteria selection as applied to options and the impact of criteria correlation on multicriteria selection. The Pareto set is shown to be an effective method for selecting option combinations. A Pareto set is defined as the set of alternatives that do not exceed, or dominate, each other, but at the same time dominate over the rest of the alternatives. The book suggests an even more effective alternative in which Pareto layers are computed, permitting expansion of the number of investment units in a diversified portfolio.

In conclusion, a wealth of information and concepts are packed into the book’s almost-300 pages. To enable the information contained here and in the corresponding articles written by the authors to have the maximum value, a trader’s computer should be programmed with the various algorithms and procedures for analyzing data, selecting the best asset combinations and ultimately assisting in forming an optimum portfolio.

The value of the book for any user would be significantly enhanced by available computer program downloads. The programs would assist in understanding the analytical portions of the text as well as permitting readers to separately try out the procedures on current market data. When the authors close by hoping that consistent application of the ideas and principles described in the book can help you construct a balanced universal trading system, one may say “What about a little help here?”