I have been searching best topic for my next article and I found something what can be interesting for all beginners in trading and especially in quantitative trading. The name of this article may sound weird but truth is that it is fact and I would like to share the way how I made this profit. The key idea of this article is not about profit. Key idea is about way how I achieved this goal. Let’s take a look on details.

My way in options trading

I spent some time by reading a blogs and community discussions about option trading. I found only one useful information. Best advice I ever read. Before you place the trade you have to analyze.

It’s pretty simple. Most of you wouldn't believe that all you need to know is find an idea which is valid. Then you have to prove it. Analyze before trade is my favorite phrase.

I don’t want to say that other informations were useless but in my case they were not powerful enough. For example there was a one dogmatic hypothesis which assumes that you as an options trader have to participate only on sell side (writing an option). You have to sell options first and then take credit premium. Reason is that value of the option is decreasing in time. This is good point and nice advantage but selling option has also very negative impact. You can lose much more than you want to. I wanted to decrease disadvantage of decreasing value of the option and I found something very interesting.

The exotic options

There are many types of exotic options but my favorite options were “one touch binary” options. Let’s see the definition from investopedia.

DEFINITION of 'One-Touch Option' A type of exotic option that gives an investor a payout once the price of the underlying asset reaches or surpasses a predetermined barrier. This type of option allows the investor to set the position of the barrier, the time to expiration and the payout to be received once the barrier is broken.




In example above you can see Nasdaq index at price 3930. Our target price is 4048. If price will reach this price you can get payout of 250% of your bet. If the price will not reach your target then your option will expire with no value.

Best advantages of those binary options are:

- you can set out your own payout ratio with setting up a level of the barrier
- you can set out your expiration date from minutes to years
- you can manage allocation of your funds
- you can sell your option anytime you want until expiration date
- you can combine your portfolio of options with different strikes and different expirations
- value of the option depend on price of underlying asset and time to expiration


Those advantages are very powerful tools and I haven’t seen any better financial instrument. There is also one disadvantage. I will mention at the end of this article.

Hard work before trading

As I mentioned before there is lot of discussions out there and nobody will tell you safe way how to benefit from solid advantage of these types of options. You have to figure it out by your own. I made tons of back tests and I found something rare. My first idea was not lose money. It may sound crazy because 100% winning ratio is not possible to find. I heard it as well but I was sure that I would like to find something very close.

The basic concept of how to not lose money

First of all I have to say that I have decided to trade market neutral strategy. Market neutral means that you don’t participate on market direction. I was no able to predict market with high winning rate so I choose do not predict on market direction at all. This simple concept assumes with entering market with two positions opposite positions at same time. Both of the orders in my strategy were BUY orders of one touch options (CALL and PUT).




Here you can see an example of opened combination order. Two orders, same time, same expiration date and time, same distance from current market price. Payout of both positions was 100%. There are only three scenarios how this trade can end up.

1st scenario – both of my orders end up at profit
2nd scenario – one of my orders end up at profit
3rd scenario – both of my orders end up at loss.

Quantitative analysis - over and over again

Many of my tests were just variations of this concept. I made tons of tests with different expirations and different barriers.
On the picture below you can see example of data-set for analysis. For this type of back test I wanted to know only: price at open, two days low and two days high. Next step was optimization of PUT and CALL touch barriers. I wanted to know percentage of my winning ratio before I place a trade. Let’s check the table of optimization example.





Here you can see table of P&L long and short legs with distance of barriers 100,120,130,140 and 150 point distance from opening price. For better understanding, look at the first 2 columns. Blue cells are profitable trades of one leg. Pink cells are unprofitable. Dark blue means that both options PUT and CALL expired on the barrier before expiration. Dark red means that both options expired with no value at time of expiration.And finally here you can see P&L expressed in number of positive and negative trades and percentage as well.



Let’s look at the first two columns. The sample of 109 trades (218 legs) when 29 trades finished with profit of 200%, 77 trades finished at break even, and only 3 trades were unprofitable with loss of 200%. The curious question is, what do you think, why I have marked these 77 trades as profitable? I always say that winning ratio of this strategy is 97.25%. How this even possible when only 29 trades finished at 200% of the original investment?

Answer is right below.

- you can sell your option anytime you want until expiration date
- value of the option depend on price of underlying asset and time to expiration

This is it, exact reason. Once your option barrier is achieved at one side (CALL or PUT), profit of one leg is 100%, but second is still there. Even if nobody knows where the price of the market will be next day, the value of this option is 10% of original investment. And this is the whole trick.


You can spread this concept to different expirations, different distance of barriers. You can redesign this market neutral strategy to many scales of directional trading. You can also calculate what profit of second leg is most efficient for maximization of profit. There are plenty of variations. I am not able to describe all of them. One thing is still clear. This model is flexible and unbreakable.

Proof of the concept - live trade report




Some of you may say that drawdowns on this chart are huge. The fact is they were minimal. These huge spikes down are just visual interpretation of close trade equity. The open trades are not visible. If one option was close, second was still in the game. That’s why visual interpretation is not exact.

Where the problem is

As I mentioned before there is one big problem. I would like to know your opinion why you think I stopped trading of this strategy. Please leave the comment in discussion below. I will write an explanation at the end of the month.

Thank you,

Airmike
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