Chapter 6. Effective Options Trading Strategies Based on Volatility Forecasting
6.3 Experimental Design
6.3.4 Options Trading Strategies
, 1
MAPE 1 |1 FV / FV |
n
i M in
i (6.5)where
^
FV
i M, is the predicted value based on the volatility forecasting model M, FVi is the realized future volatility for month i calculated on day t which is h days before the final settlement day of the option contracts, n is the number of months during the study period 2003-2007, excluding the last month for the calculation of future volatility and n equals 59. The benchmark model is simplified as MHV and the other forecasting model including the sentiment proxies based on MHV can be separately expressed as +TVIX, +TPCV, +TPCO, +ARMS and +TO. If the changes in each sentiment proxy are considered, it could be expressed as +ΔTVIX, +ΔTPCV, +ΔTPCO, +ΔARMS and +ΔTO. The algorithm of volatility forecasting recruiting investor sentiments is then evaluated through the simulation of the option trading strategy.6.3.4 Options Trading Strategies
One of the applications of volatility forecasting is to serve as a reference for the direction of future volatility. Engle et al. (1993) propose that the direction of predicted volatility change can be used for constructing trading strategies such as straddles. A combination of calls and puts could be adopted as an option trading strategy while investors have expectations regarding the movement in the underlying index. The algorithm of the effective option trading strategy proposed in this study is simulated based on a long (short) straddle and the algorithm can also be the decision support for other hybrid option trading strategies.18 The strike price of the straddle selected in
18 If an investor feels that the underlying index will move significantly, he could create a straddle by buying both a put and a call with the same expiration date and the same strike prices. If the stock price is close to this strike price at the expiration of the options, the long (short) straddle leads to a loss
this study is the at-the-money call and put option contracts on the trading day (for example, T0 in Figure 7). A large price movement implies that there is uncertainty as to whether there will be an increase or a decrease, and the volatility could be at the higher level and vice versa. The long (short) straddle is simulated while the increasing or positive (decreasing or negative) change in volatility is predicted.
In this study, the option trading strategies are simulated to compare the performance of the volatility forecasting model in terms of whether the sentiment indicators are considered or not. The long (short) straddle is set up on date T0 in Figure 7 which is h days before the final settlement day if the direction of the predicted future volatility change is upward (downward) on that day. The benchmarks of the trading strategy are based on the long (short) straddle without any filter on date T0, h days before the final settlement day. The historical volatility calculated by the last h-day standard deviation of return on date T0 is treated as the benchmark when comparing the upward (downward) movement in the predicted volatility change. The algorithm of the effective option trading strategies based on the volatility forecasting is shown in Figure 8.
The volatility trading strategies are constructed by using the TAIEX option (TXO)
h days before the final settlement day and holding it until the cash settlement. The
transaction cost is taken into consideration and includes the transaction fees, transaction tax and settlement tax.19 The cost of capital is calculated by the(profit). If there is a sufficiently large move in either direction, however, a significant profit (loss) will result in a long (short) straddle.
19 The transaction fee is calculated as NT$50 per contract. The transaction tax per contract is 0.1% of the contract value which is multiplied by the premium and multiplier. The settlement tax is 0.01% of the settlement contract value which is calculated by the final settlement price and multiplier19. The transaction tax and the settlement tax are rounded to integrals. The multiplier of the Taiwan Stock Exchange Capitalization Weighted Stock Index option (TAIEX option, TXO) is NT$50 per index point.
The final settlement price for each contract is computed from the first fifteen-minute volume-weighted average of each component stock‟s price in the TAIEX on the final settlement day. For those component stocks that are not traded during the beginning fifteen-minute interval on the final settlement day, their last closing prices are applied instead. For more detailed information, the reader should refer to the Taiwan Futures Exchange (TAIFEX) website www.taifex.com.tw.
transaction cost and the maximum margin requirement during the holding period if the trading strategies are short straddle.20 On the other hand, the cost of capital if the trading strategies are long straddle is summed up by the transaction cost and the premiums. The performance of different forecasting models is compared based on the average monthly rate of return, R(%), which is calculated as:
, 1
, 1
1 PL
R (%) 100%
1 C
n i M i
M n
i M i
n
n
(6.6)where M represents different forecasting models, and PLi,M (Ci,M) represents the profit–loss (cost of capital including transaction costs) of the option trading strategy for model M in month i.
20 The margining requirements for stock options in the Taiwan derivatives market could be summarized as follows. Margin of short call or put = 100% of option market value + max (A - out-of-the-money amount, B). A and B are fixed amounts as announced by the TAIFEX (or a percentage of margin required by the TAIEX futures contracts. Margin of straddle or strangle positions
= max (margin requirement for call, margin requirement for put) + option market value of call or put (depending on which margin requirement is less).
Figure 8 The Algorithm of the Effective Option Trading Strategies
Algorithm Application in this study
Select the proxies of sentiments by the causality test and regression-based forecast efficiency test.
ARMS, TO, TVIX, TPCV and TPCO are incorporated.
Define the control variables in the volatility forecasting model.
Simulate the trading performance by the actual option price and select the adaptive ISP.
60 days ISP is chosen.
Execute option trading strategy h days before settlement day by using the n days ISP based on the superior model