The skew has it
In addition to trading a subsystem that best fits the current state, we never take a loss. Rather, unprofitable trades gradually are converted into a GroP. For example, if there’s a trend, we’ll trade a trend-following subsystem. If a trend-following trade is profitable, we might take the profit; the unprofitable trend-following position is gradually converted into a GroP.
In this implementation of a provable system, we try to profit from both the skew and state-following, and so we obey a constraint that we trade only favorably skewed options or put vertical spreads.
After identifying the current state and employing the trading system that seems to best fit the current state, we then assign specific values to its system parameters, such as strike prices and time to expiry. We trade mainly options from the current GroP. Usually we build GroPs by trend following.
Specifically, we build the GroP in steps so that each step corresponds to a state of the market. For example, we might gradually form GroPs by starting with a position for a fast trend and converting it into a GroP only if there is a ChoST. If there is a fast trend, then we build more positions to profit from it, but if not, then we convert our current position that can follow slow trends. If the slow trend persists, then we build more such positions, but if the market gets choppy, then we establish ChoST positions.
If there is an uptrend, we write far OTM puts or vertical put spreads, or we hold OTM calls. If there is a downtrend, then we may buy a near-the-money put or vertical put spread. But if there is now a ChoST, then we gradually convert the current position into a GroP, or we write far OTM puts or vertical put spreads. If the ChoST continues, then we wait until the state changes.
Writing far OTM puts via well-designed put spreads may be profitable in four of the five states, or up to 85%-90% of the time.
Writing far OTM puts or vertical put spreads may lose only if there is a fast downtrend, but in this case we follow the downtrend by holding near-the-money puts or vertical put spreads, and we try to profit from the downtrend.
There two ways we can demonstrate profitability of our systems: Practically and theoretically.
We can show the effectiveness of POTS by trading it and comparing system returns to market returns. The average expected market return is 10% to 11% per year, but to earn this return, we have to take a rather high risk, including occasional equity drawdowns of more than 50% during bear markets.
Because our system can require frequent position adjustments, it is critical to use a low-cost electronic trading platform for executions. Transaction costs, at the time of this writing, range from about 15¢ to $1 per option.
Current estimated annualized returns on margin are about 15% to 20%, and the risk is less than market risk. For instance, during testing drawdown has not exceeded roughly 5%.
The three pillars suggest that most of the time the traded subsystem fits the current state of the market. In addition, system rules dictate that we CoFT—but we never cash out with a loss—unprofitable trend-following trades are converted into a GroP.
By definition, the GroP can only grow, at least temporarily. About one-third of trend-following trades are immediately profitable, and the unprofitable trades are converted into GroPs.
Moreover, because the system only trades options, risk is manageable. It is always within our power to set an upper limit on our risk. Of course, by lowering risk, we also lower our expected return.
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 firstname.lastname@example.org.