Thursday, November 17, 2016

Super Stupid Option Premium Skew

Now, this is irritating. Nifty Spot closed at 8090.95, and Nifty November Futures closed at 8075.25. Now, December 2017 Nifty 9000 Call that is 909 OTM is available at around 337, and December 2017 Nifty 8000 Put that is 91 OTM is available at around 338. Why is a 909 OTM option and a 91 OTM option available at the same price?

Market Depth - Nifty December 2017 9000 Call
Nifty December 2017 9000 Call - 909 OTM for ₹337

Market Depth - Nifty December 2017 8000 Put
Nifty December 2017 8000 Put - 91 OTM for ₹338

These LEAPS options do have sufficient market depth to allow accumulation.

I might be wrong, but I think that 8000 is considerably closer to the the current Nifty Spot Price than 9000. Do the big option players think differently? Why is there a persistent skew overpricing Calls in comparison to Puts? What am I missing?

Isn't there free money here, like I have posted about the Premium Skew in July this year? I have been periodically observing the Premium Skew, for at least 3 years now. I had even attempted to trade it once, but got bored after a couple of months (See my post in Traderji about it). I just don't have the patience needed to pull it off. Maybe, it does not match my temperament, or maybe it is just that I don't have sufficient capital to make a big killing on it, or maybe it's just that I have got better stuff to do ☺

Or, maybe I just don't understand this stuff at all. Such is life.... Skew my life!!

Wednesday, November 16, 2016

Better Opening Range Breakout - the Overnight Gap setup

In my earlier post about Opening Range Breakout, I had mentioned a very simple way to trade the Opening Range Breakout. It was a simple trading system, where upon completion of the ORB period,  entry triggers were placed above and below the Opening Range.

That system had a positive expectancy - both in backtests as well as real trades. I mainly tested and traded that system on Nifty50 futures. The issue with that system was that it was given to huge drawdowns. With optimizations, the win rate ranged between 20% to 30%, with a reward-risk ratio of 4:1 or more.

I have been testing Opening Range Breakout with different parameters, and one of the obvious tasks is to attempt to improve the win rate to minimize drawdowns. This process is still work-in-progress, but let me share one of my findings.

The tests were done on the NIfty50 Future data of the last 4 years. I find that if Opening Range Breakout trades are taken only when there is a significant overnight gap, with a few optimizations, the win rate jumps to between 50% and 55%, though the reward-risk ratio goes down to between 1.6 to 2.0.

Compare the 2 results:

System   My Old ORB System    ORB with overnight gap filter 
Win Rate 20% to 30% 50% to 55%
Reward-Risk Ratio 4.0 to 6.0 1.6 to 2.0

I have given ranges for the Win Rates and Risk-Reward Ratio, but keep in mind that the Win Rates and Risk-Reward Ratios generally have a inverse relationship. So if I optimize the old system for a Win Rate of 20%, then the Risk-Reward Ratio would be closer to 6. Similarly, if I optimize the old system for a Win Rate of 30%, then the Risk-Reward Ratio would be closer to 4.

Which system would you choose? Applying the Kelly Criterion to maximize returns, the choice would generally be to go with the overnight gap filter.

While using the old ORB system, the Kelly Criterion would restrict the capital risked per trade to between 6% to 12%  and have an expected return of 2 to 10 times the initial capital per 100 trades. (The results that I got while trading the system were closer to 2 than 10). With the Overnight Gap filter, due to its higher win rate, the capital risked per trade according to the Kelly Criterion would be 15% or more, giving a minimum expected return of 25 times the initial capital per 100 trades.

But again, let me put the disclaimer. There are no minimums in trading. If you have the bad luck to hit a bad drawdown, or a big slippage, or makes typos, or go psycho... then there are no minimums... psycho gamblers especially have the talent of getting account balances below zero very quickly. Even ignoring all the bad luck and bad psychology, there is no guarantee that the market will continue to behave the way it did in the past to make Opening Range Breakout a successful Trading System. These are estimates based on past data, and not a prediction of the future performance.

Below, is an image on the how the ORB trades with overnight gap filter panned out on the November Nifty50 H1 charts. The Yellow bars indicate the days on which the setup occurred.

Opening Range Breakout with Overnight Gap

I have also found a few setups that can increase the expectancy of Opening Range Breakouts further... but the study is still in progress.

Thursday, November 3, 2016

Kissing the frog - Trading System evaluation

The Prince of the Markets

Once upon a time, not so long ago, there was a Prince (in reality, a pauper) called Augubhai, who was attracted to every Trading System that caught his eye - as though the Trading System were a Princess. He would embrace the Princess whole-heartedly, close his eyes and kiss her - only to realize that the Princess was a frog, when he opened his eyes.

Disappointed, but not disheartened, he would muster vim, and with renewed vigor, he would resume his search for his ideal Princess. And then he would embrace her whole-heartedly, close his eyes and kiss her - only to realize that it was a frog - like always.

The Prince was smart fellow (in reality, a stupid fellow - but this is a fairy tale). One day, while thinking with the core logical part of his left brain - just as logically as Archimedes did long, long ago - he had an eureka moment. He realized that every time he kissed a Princess, it turned out to be a frog. So, logically, if he kissed a frog, it should turn into a Princess. It was so logical a postulate, that he was surprised that it took such a long time for a smart fellow (in reality, stupid) like him to discover it.

The reality of the Markets

But the Prince finally realized that his postulate was not working. As they say, the reality of the markets is different from the reality of logic and reason and Archimedes. As they also say, it is yucky, and not easy to kiss frogs. Kissing frogs did not turn them into Princesses - at least, not too often. Kissing frogs needs you to discard irrational exuberance that this one will be a Princess. But you also need that little hope - a low probability hope - that there would be a Princess somewhere out there. This hope is not like a exuberance of a lottery buyer, because kissing frogs is much harder than buying the lottery.

The Prince stopped trading every random Trading Systems that seemed visually, logically and/or emotionally pleasing. Trading Systems that appeared to be visually, logically and/or emotionally pleasing seemed to be Princesses, but in reality, most were frogs. The records of the Prince trying out random Trading Systems, day after day, month after month, year after year can be found in the Princess Diaries in the Traderji forum:

Persistence and Perseverance

Now the Prince takes a hard look at Trading Systems before trading them, backtesting and scenario testing them, before actually trading them with money. After all, these Trading Systems are mostly frogs, and frogs rarely turn into Princesses. The spirit of what the Prince does now is similar to what he describes in these pages at Traderji:

The Prince has even frog-zoned the Opening Range Breakout system, at least for now. Even the Range Compression Trading System that he traded earlier this year is out of his embrace. These systems were really beautiful, enticing.... closer to being Princeses than frogs. But Princesses need more refinement and polish, and maybe with some refinement these Trading Systems may turn out to be real Princesses.

Hope... hopefully, not irrational

Fairy tales do not have sad endings... and neither does this one. The Prince actually did kiss a frog that turned out to be a Princess. That is the Trading System that the Prince trades currently. With the application of the Kelly Criterion, the Prince thinks that he will soon amass wealth and riches far beyond his imagination. But the due to past experiences, the Prince has the nagging fear that this Princess would also turn into a frog one day. To mitigate the fear, the Prince continues to evaluate other Trading Systems, continues to kiss frogs in the hope of finding more Princesses to enhance his harem.

One probable reason why the Prince went on the Princess kissing spree earlier, was because he did not have a Princess, and was desperate to find one by any means. Now that he already has a Princess, he is now more choosy and strategic about kissing frogs.... well, at least this is what his psychologist thinks.

Fairy tales have morals. What do you think is the moral of this story?