The skew has it

March 16, 2015 12:00 PM

Continually follow the trend: To CoFT is the best way to minimize risk. We CoFT without taking any losses. That means that the unprofitable trend-following positions are gradually converted into GroPs. And as the state of the market changes, we continually trade to adjust our options portfolio accordingly.

“State” refers to the state of the market (the QQQ) and the state of the options portfolio (see “State breakdown,” below). Therefore, if we mean only “state of the market” or only “state of our options portfolio,” then we must say so explicitly.

The two most important market state features include its current trend and volatility. The trend can be up, down or flat. Volatility can be high/fast or low/slow. By combining these two state features, we come up with six market states: 
1) fast uptrend, 2) fast downtrend, 3) slow uptrend, 4) slow downtrend, 5) fast choppy, 6) slow choppy. The last two states are equivalent because we map them on the same trading subsystem. 
So we combine them into one state called ChoST for “Choppy, slow and/or trendless.
The market is in an uptrend about 40% of the time, in a downtrend 30% of the time and is ChoST about 30% of the time. These are state probabilities suggested by random walk theory.

The two most important features describing the state of our options portfolio are portfolio delta and theta. Both features depend on the state of the market. 

In the short-term time horizon, we assume the market is an almost pure random walk: Its future is unknown, uncertain, unpredictable and unexpected. The market can do almost anything at almost any time. But we also assume the current market state will continue until there is some evidence that the state has changed. This is the state continuation principle. Trend following is an attempt to exploit this principle.

There is usually little or no correlation between market states, and usually current state probabilities are approximately equal to their random walk probabilities.

Pots structure 

Our provable options trading systems (POTS) is designed as a hierarchically organized structure of simpler subsystems that we can understand and describe.

We need a different trading subsystem for each market state. We also need a main control subsystem that implements the SSMap, risk control and conflict resolution. We organize these subsystems hierarchically with the main control subsystem at the top. “System map” (below) summarizes the structure.

The trading strategy is continually dynamically formed by the main control subsystem (MCS) so that the current trading scheme constantly changes depending on the market state. The main tasks of the MCS include implementing the SSMap, risk control and conflict resolution. The MCS is designed so that our system should perform well without the need to predict future market states, but the ability to predict the future should boost its performance.

We sometimes realize the SSMap by simultaneously trading several complementary subsystems, but we emphasize the subsystem that best fits the current state. For example, because we don’t know the current and future state, we sometimes simultaneously trade at least a trend-following subsystem to guarantee we’ll profit from every big trend, and if there seems a ChoST, then we trade a subsystem for that state too.

With options, we easily can quantify our risk, and we can set an upper limit on the risk we take. Of course, the best way to minimize risk is to follow the current state continually.

A major function of the MCS also is to resolve conflicts among trading rules.

As for the subsystems, the one we use to follow fast downtrends is quite different from the subsystem we use to follow fast uptrends. And the subsystems needed to follow slow trends differ from the subsystems for fast trends. Of course, the subsystem we trade if there is a ChoST is thoroughly different from our trend-following subsystems. So we need several trend-following subsystems and at least one subsystem for the ChoST state. We try to integrate these trading subsystems in a way that makes the total system more profitable than the sum of its parts.

We do not attempt to anticipate the next state of the market. Our provable systems are designed so that we do not need to predict anything. We assume the future of the market is uncertain. We always assume that the market will try to hurt us. If a mistake gives the market a chance to harm you, it will. 


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About the Author

Jerry Felsen is a trader, writer and university professor. He has published eight books and dozens of papers on computer applications  for investment management. He is now managing his First Alpha Fund. Reach him at