Overlaying Options Spreads on a Technical Trading Strategy

Options are complex financial instruments that often attract sophisticated traders and investors. In investment banks and hedge funds, they’re often the instrument of choice when one wants to engage in sophisticated trading strategies such as volatility arbitrage, dispersion trading. Another important role of options is for hedging and risk management purposes. Recently, there is a growing trend in the use of options in directional trading; that is, investors overlay options on an existing directional strategy.

A recent article [1] examines the use of options as instruments for technical/directional trading. The author proposed a strategy as follows,

When SMA(50) is above (below) upper (lower) bollinger band a call (put) spread (selling call (put) out of the money and the buying a further out of the money call (put)) slightly out of the money with an expiration date of 4 days. This strategy can be done with index, stocks, commodities and forex.

The author then evaluated this strategy on 2 US stocks and an index ETF. He concluded,

Starting hypothesis were correct, options are a really flexible financial derivative for trading and could be an effective means for trading if are supported by a correct use of technical analysis. Using leverage in low volatility periods often led to higher profits. This strategy perform well in financial markets and the author believe that it can be improved with some effort maybe selling naked options or using as described before as call spread on vix to hedge black swan events. For further improvement a trader can evaluate selling call spread out the money, in case of SMA (50) over upper bollinger band and buying a put spread out of the money. The strategy could be implemented with an important money allocation on low volatility periods while using a far lower capital during higher volatility periods. It will be necessary to open maximum one trade during low volatility periods and not more than three on high volatility. Capital not used could be invested in SP500 giving to the trader a much higher profit.

The results are consistent with our experience. However, the article did not discuss important points such as,

  • Were the risk-adjusted returns improved, and if so why,
  • How to select the strikes for the options spreads, what the optimal strikes are?

 References

[1] F. Carlier, A Simple Options Trading Strategy based on Technical Indicators, International Journal of Economics and Financial Issues, 2021, 11(2), 88-91.

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