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**Strategies for Equity Options
**

MS&E 448 Project Report

Gilad Ashpis

Gino Rooney

Ian Schultz

Zach Skokan

Department of Management Science & Engineering, Stanford University

June 9, 2014

1

Project Introduction

V

**olatility is an increasingly important asset class in finance and trading, and therefore an
**

understanding of the dynamics and idiosyncrasies of volatility markets is important to

holistic market modeling. Throughout the course of the project, we explored several different

volatility models in hopes of better understanding the dynamics of volatility and finding

profitable trading strategies based off of them. Our modeling techniques can be broken down

into two categories: fitting the implied volatility surface and time-series volatility modeling.

For both categories of models, we formulated and back-tested trading strategies. For several

of the strategies tested based off of our models, we found desirable returns compared to that

of the market portfolio. The paper is organized as follows: in Section 2.1, we provide a brief

overview of the necessary finance needed to understand the project. Sections 2.2 - 2.3 review

the data collection and visualization process. The remaining sections of part 2 go over the

theory behind the volatility models we explored. In part 3, we explain and analyze backtested strategies, which includes a section on portfolio construction and risk management.

Lastly, we conclude with some final thoughts and ideas for future work.

2

2.1

A

**Volatility, Data, and Modeling
**

Background

n equity option is a derivative contract that gives the holder the right, but not the

obligation, to trade the underlying equity under specified terms. Typically, an option

1

however. for a non-dividend paying stock. The risk-free rate may be estimated in a number of ways. The option premium refers to the observable price of the option as traded in the financial markets. for instance). while a European option only allows for exercise on the expiration date. it is assumed that the risk-free rate is known and constant. t) = SN (d1 ) − Ke−r(T −t) N (d2 ) where ln(S/K) + (r + σ 2 /2)(T − t) √ σ T −t ln(S/K) + (r − σ 2 /2)(T − t) √ d2 = σ T −t d1 = K is the strike price. and σ is the equity volatility. The trading strategies developed later in this paper will focus on call options because of computational ease.) is the standard normal cumulative distribution function. a call option is the right to buy the asset. the analytical solution C(S. prices take on a more “fat-tailed” distribution (see Borland 2002. and there are no market frictions such as transaction costs or penalties for short selling. The Black-Scholes model (Black & Scholes 1973) is the classic framework for option pricing. Although the formula is derived for a European call. r is the risk-free rate.contract specifies the strike price at which the equity can be traded. but in the specific case of a European call option. while a put option is the right to sell the asset. Stock prices at any given future date are assumed to take a log-normal distribution. In reality. the model provides a reasonable and convenient pricing formula. K. (T − t) is the time until expiration. Black-Scholes pricing relies on several key assumptions. since it can be shown that. the option should never be exercised prior to the expiration date. Despite its shortcomings. The option will be exercised if the payoff exceeds zero. while for a put this occurs if the stock price is less than the strike price. Furthermore. the stock pays no dividends. the option premium f (S. t) exists and can be expressed as: C(S. the formula is not particularly sensitive to this input. for a call this occurs if the stock price is greater than the strike price. in theory. Typically no analytical solution to this equation exists. Two primary styles of options are commonly traded: American and European. S. it can also be applied to an American call. while r and σ must be computed from observable market data. Rather. and one of the most widely adopted options pricing methods in the financial industry. Additionally. 2 . t) satisfies the partial differential equation: ∂f 1 ∂ 2f 2 2 ∂f + rS + σ S = rf ∂t ∂S 2 ∂S 2 where S is the underlying equity price. Assuming the price dynamics of a stock are described by geometric Brownian motion. and N (. In the Black-Scholes formula. An American option allows the holder to exercise the option at any time prior to the contract expiration. and (T − t) are readily observed in the market. and during which time period it can be exercised.

higher volatility of the underlying equity translates into a more valuable option. and exercise style. expiration date. like the risk-free rate. and Apple (Ticker: AAPL). the mid price was computed from the bid and ask spread. delta changes constantly as the time to expiration and the stock price change. over the period 2005-2013. Option contracts are written on 100 underlying stocks and are priced accordingly. it is the value that is implied by Black-Scholes. Managing and cleaning the data was a non-trivial task. can be constructed by offsetting the negative delta exposure from call positions with an equity position in proportionate weighting. which allows a trader to bet on the price of the option only without betting on the direction of the equity. one might observe a volatility smile. The holder of an option is exposed to the risk associated with the price movements of the underlying equity. Each option 3 . To approximate realistic trading execution prices. This risk can be hedged away by constructing a delta neutral portfolio. Although volatility. a trading opportunity presents itself. for each option with a unique strike price. The delta of a portfolio is simply the sum of the deltas of the individual assets. The options we examine are the SPDR S&P500 exchange-traded fund (Ticker: SPY). The dataset exceeded the capacity of a Microsoft Excel spreadsheet. Delta is defined as: ∆= ∂f (S.2 Data Procurement and Cleaning D aily historical options data were sourced from the OptionMetrics database. the volatility can be obtained from the formula because all other inputs are known. 4 million daily quotes were available for all options written on the SPY index. The majority of the records consisted of options with no trading volume. In order to maintain a delta neutral portfolio. A portfolio with delta equal to 0. Trading costs must be taken into account when deciding on the frequency of rebalancing. Each record consists of the best bid quote and ask quote for a specific date. When looking at a curve of implied volatilities plotted against different strike prices for a given expiration date. so by necessity the data pre-processing was performed using python. These were selected for being amongst the most actively traded names. if one assumes a certain risk-free rate. or delta neutral portfolio. However. This quantity is referred to as the implied volatility. The implied volatility of an option with strike price far from the current stock price is often higher than for one with a strike price near the current price. t) ∂S This measures the sensitivity of the option premium to changes in stock price. these were removed from the dataset. is a theoretical quantity. The implied volatility can be interpreted as the market expectations for volatility between the current date and expiration. regular rebalancing of the positions is required. the delta of a unit of stock is equal to 1. since rather than being directly observable. In short. 2. Google (Ticker: GOOG). for instance.the volatility is of much greater significance. Delta is equivalent to the quantity N (d1 ) from the Black-Scholes formula. If one believes that the actual expected volatility deviates from the implied volatility. Moreover.

we also created a 3D plotting method that would graph the entire implied volatility surface on a given day.S. To do this. was used as a proxy for the risk-free rate. visualizing the volatility smile and surface was the central focus of this step. Similarly.record had to be matched with the equity price for the current date. our next objective was to visualize the data to make sure that it was consistent and identify any potential sources of error. sourced from OptionMetrics. Figure 1 shows an example output from these methods. the complete term-structure was obtained by linear interpolation and matched to each option by expiration date. Daily historical equity prices were sourced from the Center for Research in Security Prices (CRSP). and contours of the resulting implied volatility smiles from the fit. Using our implied volatility calculator.3 Data Visualization A fter the necessary data had been procured and appropriately filtered. which provides a clean price series adjusted for dividends. the implied volatility was extracted from the Black-Scholes formula using the bisection method. 4 . we were ready to start modeling the data and brainstorming potential trading strategies. Since rates are only available for a limited number of maturities. and other corporate actions. we wrote a method to plot the volatility smile for any set of expiries on a given day. Since our project largely relied on spline fitting the implied volatility smile. splits. a fitted thin-plate spline. 2. Furthermore. Treasury curve. Finally. We found that this data visualization step and the methods we created to help with it were particularly useful in identifying anomalies in the data that we encountered upstream in analyzing our trading strategy. the risk-free rate had to be merged into the dataset. The zero-coupon U. we wrote several python scripts to plot features of the data. Figure 1: Implied volatility smile and surface plots from the data visualization step Now that we had taken measures to enable visualization and verify the general consistency of the data we collected.

. The date of this fit is 08/15/2007 on the set of options with 66 days to maturity.2. it can be solved quickly. ω2 . Efficient storage was useful for us since the options data we were dealing with was already large. consequently. To find such opportunities. Including such conditions results in a convex quadratic program whose solution provides us with an arbitrage-free call price function and. because the problem is cast as a convex quadratic program (QP). 1995). in polynomial time (Flouda and Viswewaran. which guaranteed our results were repeatable. Furthermore. Figure 2 shows an example of such plots from our implementation. our spline fits could be efficiently stored and evaluated. The approach we took to create arbitrage-free spline fits was first described by Matthias Fengler and is summarized below (Fengler. ωn and smoothing parameter λ. one of which sought to create an arbitrage-free spline fit to the implied volatility smile. Secondly. we employed several modeling techniques. an arbitrage-free implied volatility smile.b] of exercise prices with the same days to maturity on a given day. our next step goal was to find tradeable opportunities in the data. the zoomed in fit shows more visually noticeable residuals. we can preclude calendar arbitrage by iteratively solving this optimization problem for each set of expiries on a given day and imposing additional constraints based on the previous fit’s results. because a natural cubic spline can be completely defined by its set of function values and second-derivatives at the knots. Formulating the spline fitting problem in this way provides us with several benefits. This minimization is carried out with chosen linear constraints to ensure our fit is a natural cubic spline. tradeable residuals between our arbitrage-free price and the market price of an option. a universal numerical optimization package that contains several of its own solvers as well as other popular open source solvers. The problem of fitting a cubic smoothing spline to option prices can be solved with the following convex optimization problem: Z b n X 2 [g 00 (v)]2 dv min. Finally. It was our hope that we could then find large enough. where (yi . ωi {yi − g(ui )} + λ a i=1 given strictly positive weights ω1 . This speed proved useful to us in back-testing our strategy as we needed to solve this QP multiple times a day (for each set of expiries) for 8 years. As seen and further discussed 5 . the spline fitting for all of our arbitragefree smiles took only around 10 minutes to complete. Firstly. In consequence.. 2005). There are also plenty of available solvers for QPs. This minimizer gˆ provides us with a call price function for a volatility smile whose smoothness is determined by λ. the minimizer returned is unique. Constraints are also added to guarantee that the call price function is non-increasing in the exercise price.4 Arbitrage-Free Smoothing of Volatility Surfaces O nce the data’s cleanliness and consistency had been observed from our visualizations. . ui ) represent a single option’s market and exercise price respectively over the set [a. While the residual between the market and arbitrage-free price is difficult to see in the entire fit. We utilized the OpenOpt framework for python. We wrote python scripts to transform this definition of a cubic spline into a piecewise polynomial that we could use to evaluate and plot our spline fits.

and our strategy seemed to perform best during these time periods for the SPY.04. Once we had successfully constructed our arbitrage-free fits. For this fit. Thus. the residual plot shows differences of up to ∼1% between the market and arbitrage-free price. this day occurred during a time of high market volatility according to the VIX index. Figure 3 shows a plot of the percent residuals from the same fit versus the strike price. Fig. in section 3. this signals a lower market price than what our arbitrage-free fit suggests. The motivation for the strategy we ultimately tested came from examining an option’s residuals and the progression of them over time. 3 displays a typical range of residuals found in our spline fits.Figure 2: Resulting arbitrage-free spline fit for options with 66 DTM on 08/15/2007 and underlying of $141. our fit suggests that this option is currently undervalued. Figure 3: Residuals between arbitrage-free spline fit and market prices for options with 66 DTM on 08/15/2007 and underlying of $141. When there is a positive residual for a given option.1. we sought to identify potential trading strategies. Figure 4 shows how the 6 .04.

Thus. This differs fundamentally from the first strategy in that it attempts to speculate on volatility movements.1. Thus. we can see a trend that the option’s residual reverts back to zero (or some small value). GDP growth. Despite these favorable values. Among these were interest rates. The decision parameters and more details of this strategy are described in Section 3. and consumer sentiment.e one month volatilities based on quarterly delinquency rates). We found this to be the case for all of the options we examined.5 Time-Series Volatility Prediction Modeling The other strategy we sought to investigate was using time series models to trade on volatility forecasts. If we predict that the volatility over the term of an option will be different than the implied volatility based on the market.1. they tend to converge back to an appropriate value in the ensuing days. making an actionable model that uses real-time data 7 . Our linear regressions excluded a constant term and therefore were of the form: yj = n X βi xji i=1 While testing different regressions based on macroeconomic factors. From this plot. whereas the other looks for arbitrage opportunities based on current prices. This inspired our strategy of buying or selling under or over valued options and realizing their profit on the following day.residual of an option changes over the life of the option. and often quite quickly. when options become under or over valued according to the arbitrage free price. One of the most important flaws in these models is that our dependent and independent variables do not always have the same time horizon (i. we did come up with some models that seemed promising by strictly looking at their R-squared and p-values. The first type of volatility modeling we attempted was a linear regression over different macroeconomic factors. Figure 4: An option’s day-to-day residual over its life 2. a trading opportunity is presented. there are some flaws in these models that make them less than desirable.

if one looks at past volatility along with the economic factors. which is illustrated by Figure 5 . EGARCH. ARCH models can capture how market volatility changes over time. which affect the number of lag coefficients to be estimated by the model. on the other hand. one can see there is significant collinearity. EGARCH can treat positive and negative past returns differently in making its forecasts. The next type of time series models we tried were different models from the ARCH (Autoregressive Conditional Heteroscedastic) family of models. Note the clustering behavior. Figure 5: Weekly Log Returns of S&P 500. LLC) led us away from using a linear regression on macroeconomic factors and towards our next type of regression model. 8 . Thus. GARCH uses the squared error. This would be useful because the S&P 500 returns exhibit a clustering behavior. uses the magnitude of the error as well as the actual error. we decided to model five-day volatility using the GARCH and EGARCH models.would thus be a challenge. Furthermore. The volatility for these two respective models take on the following form: GARCH: σt2 =κ+ p X 2 αi σt−1 + q X βj ε2t−j j=1 i=1 EGARCH: log(σt2 ) =κ+ p X 2 αi log(σt−i ) i=1 + q X βj (|εt−j | + γi εt−j ) j=1 One must specify p and q. Specifically. These flaws (along with the advice garnered from our talk with SpiderRock Holdings. There are obvious periods of lower volatility and others of higher volatility. Our models regress on a time series of five-day log returns. canceling out the effect of sign. The main difference between GARCH and EGARCH is an assumption about the effect of lagged error.

back-test results here represent a worst-case scenario as the algorithm potentially trades out of and into the same position each day. In other words. In many cases. each trading opportunity on a given day is assigned an equal share of the total portfolio value. which adds unnecessary transaction costs. The data tested positive for skew and kurtosis. Transaction costs were assumed to be $0.1 Strategy Back-Testing and Results Volatility Skew Surface Arbitrage By comparing arbitrage-free spline fit volatility surfaces to market prices. These volatility skew-arbitrage trading strategies were explored for options on three underlying assets: The State Street Global Advisors S&P 500 exchange-traded fund (SPY).005 per share for both equity and options.3. the entire portfolio was sold at market prices and a new portfolio was purchased using the updated arbitrage-free spline fit and market price residuals. When the magnitude of the residual between the two prices was larger than a threshold value (in the examples here. tradeable mispricings and inefficiencies in the options market can be identified and traded upon. Therefore. However. In this way. This concept is at the core of several different back-tested trading strategies presented here. there are potentially many trading opportunities each day. 9 . with an absolute magnitude greater than $0. in the residual-weighted case. the entire data set was considered out-of-sample and was used for back-testing. the contract would either be bought or sold. no other efforts to hedge sensitives were made. Contracts within four days of expiration were not considered in order to avoid the need to exercise options. Because these criteria were chosen arbitrarily. hundreds of different option contracts are traded each day for a single underlying instrument. the residual was required to be larger than 0. Each position was delta-hedged with the underlying security at the market mid price in order to minimize sensitivity of the portfolio to movements in the underlying asset. as well as for ARCH effects (using the Ljung-Box Q-test). The daily closing mid price (the average of the bid and ask prices) on each call option was compared with the arbitrage free spline corresponding to the same strike and time to maturity and the residual between the two prices was computed. We will go more into the estimation of our models and results in Section 3. each position was sized according to the its residual normalized to the total residual of all positions entered on that day.Before proceeding with implementing these models. each position was sized according to the size of its corresponding residual. we explore two different strategies: uniform and residual-based position weighting. we tested the data to ensure these models were appropriate. 3 3. The results demonstrated that our data does have the characteristics of something that can be modeled using the ARCH family of models. and rules must be implemented in order to divide assets allocated to this strategy among the many different opportunities.01 per share). Conversely.5% of the option price. depending on the sign of the residual. and therefore the returns here are potentially partially affected by other Greeks. After holding the portfolio for one day. Here. In the uniform weighting case.

there is noticeably less volatility in the equity curve. and the large spike near the middle of 2007 is reduced to a significant but small jump in the equity curve. Both strategies use the same trading rules. However. It also suffers from significant drawdowns. Therefore. this study provides insight into how the strategy scales with the depth of the options market. with an average return of about 0. Options markets on these three names have varying degrees of liquidity.14)3 . this time using the residual-based weighting scheme. Large index-tracking ETFs such as SPY typically have significantly deeper options markets than individual stocks. A particularly strong information ratio is achieved in the residual-weighting case. Nevertheless. large spike around mid-2007. followed by a rapid. and these are also shown in Table 1. there is fairly consistent initial growth. The hit rate for this strategy is 56.com/invest/technicalIndicator/SPY–Information-Ratio 2 10 . The right hand plot in Fig. In the same one-month period.cboe. Table 1 contains relevant descriptive statistics for the back-tests of skew-arbitrage trading on the S&P 500 options. This period corresponds to the same period of rapid gains and subsequent losses in the uniform-weighted case. Statistics unique to each implementation of the strategy include annual return. After around mid-2009 the strategy equity shows no drastic jumps or dips and there are only modest positive returns.000 GOOG contracts changed hands 1 . this information ratio is actually quite strong when compared to a static position in SPY (IR = 0.macroaxis. average return on winning trades. while only 200. common stock (GOOG). and Apple Computers Inc. there is an enormous spike in the equity value during the period of late-2008 to early-2009. and therefore the fraction of days traded. Here.com/data/AvgDailyVolArchive. At the end of 2009. but not spectacularly so.cboe. 6 shows the same back-test period results.aspx 3 From http://www. and max drawdown. and average loss on losing trades are all the same. This is followed by relatively stagnated performance and increased volatility in the equity curve. For the uniform weighting case (left plot).Google Inc. Although the uniform-weighted strategy has a higher annualized return. This is because the standard deviation of returns is around 5% on an annualized basis for this strategy.55% on both wins and losses.1. for example. which is quite strong for an inter-day strategy. which smooths the returns significantly. the equity curve suddenly spikes upward and then rapidly shoots down to its previous level again. which corresponds to the largest drawdown experienced during this test.1 Performance of Volatility Skew Arbitrage on the SPY Options Market Back-test equity curve results (net of costs) for the volatility skew-arbitrage strategies with uniform weighting and residual-based weighting are shown in Fig. the strategy settles down and is profitable.aspx Data collected from http://www. Subsequently.2%. 3. in May 2014 over two million AAPL contracts were exchanged. hit rate (defined as the percentage of total trades that are profitable). the information ratio of this strategy is much smaller because the variance of returns is very large. 6.com/data/monthlyvolume. common stock (AAPL). for SPY there were nearly 12 million contracts exchanged 2 . These results show that the strategy trades on about one-third of all days. information ratio. Another important consideration is that the maximum drawdown of 1 Data collected from http://www.

dislocated markets in periods of high volatility. from about July 2008 through July 2009. whatever the price.5% 32.55% 0. To confirm these suspicions.57% the residual-weighted strategy is more than an order of magnitude smaller than the uniform weighting case.2% 0. the total equity grew by more than 30% over a series of profitable trading days.27% 1.Figure 6: Equity growth curves for skew-arbitrage trading strategies on S&P 500 options. Annual Information Strategy Drawdown Traded Rate Win Loss Return Ratio Uniform 22.23 5. a more detailed study was performed in order to better understand how these returns are generated.55% 0.3% 0. We see that from about October of 2008 through February of 2009.2% 0. In these market conditions it is more difficult for market participants to arbitrage away small inefficiencies in the volatility skew surface.84 55. which is a measure of market expected 30-day volatility on an annualized basis.0% 56. Left: Positions taken each day are weighted equally. It is evident from this comparison that the increased returns and performance of the skew-arbitrage strategy corresponds nearly directly with increased volatility beginning around October 2008 and continuing through about April 2009.30% 32. It was suspected that this high-return period corresponded to stressed. and many participants are likely more concerned with hedging delta risk on the options market. This characteristic is particularly desirable because many funds take fees based on a so-called “high-water” mark.57% Weighted 6. Max.0% 56. Days Hit Avg. Figure 7 shows the one-year portion of the residual-weighted S&P 500 curve with the largest gains. Because a large portion of the total positive returns of each strategy are generated during relatively short time periods. This result suggests that volatility skew arbitrage is a 11 . the equity curve was qualitatively compared with the S&P 500 volatility index (VIX). Table 1: Performance statistics for volatility skew-arbitrage trading strategy on SPY. Avg. Right: Positions taken each day are weighted according to residual magnitude. and therefore significant drawdowns make trading strategies particularly undesirable.

Figure 8: Single-year history of the VIX. Figure 7: Single-year equity growth for skew-arbitrage trading strategy using residualmagnitude weighting on S&P 500 options. Additional work could incorporate regime modeling in order to enact this strategy only when market conditions are favorable. the equally-weighted strategy 12 .2 Performance of Volatility Skew Arbitrage on the AAPL Options Market Figure 9 shows equity curve growth for equally-weighted (left) and residual-weighted (right) positions on AAPL options. which measures market volatility based on S&P 500 options.particularly attractive strategy during periods of elevated volatility.1. 3. As before with SPY options.

23% -0. Loss 1. Avg. Because the equal-weighted strategy provided negative returns.48% 48.Table 2: Performance statistics for volatility skew-arbitrage Max.1.3 Performance of Volatility Skew Arbitrage on the GOOG Options Market In a third study. Equity growth time-histories are shown in Fig.2% 22. and actually provides negative returns over the back-test period. We also observe that AAPL options provide fewer trading opportunities than SPY. respectively. However. Left: Positions taken each day are weighted equally. it has a negative information ratio. The information ratio of the residual-weighted strategy corresponds approximately with a static position in the S&P 500. they are larger in this less liquid option market. Right: Positions taken each day are weighted according to residual magnitude. 10 for both equally-weighted (left) and residual-weighted (right) strategies. Figure 9: Equity growth curves for skew-arbitrage trading strategies on AAPL options.41% under-performs the residual-weighted strategy. we see that the same high-volatility period 13 . the residual-weighted strategy provides only very small total returns over the back-test and is highly volatile compared to returns with the same strategy on SPY.9% trading strategy on Hit Avg.2% 1.9% of days. Here.2% 1. when the strategy does trade the average win and loss of profitable and unprofitable trades.9% Weighted 1. Strategy performance statistics for the volatility skew-arbitrage strategies on AAPL are summarized in Table 2. Days Annual Information Strategy Drawdown Traded Return Ratio Uniform -7. However. is near three times larger than the SPY results. This suggests that when mispricings exist. Rate Win 48. as both strategies trade on only 22.13 31. the volatility skew-arbitrage trading strategy was back-tested on GOOG options. 3.46% 0.48% AAPL. in this case.4% 22.41% 1.31 75.

44% 0. Days Annual Information Strategy Drawdown Traded Return Ratio Uniform -30.2% 2.68% 2. note that for this market.0% Weighted 5. Figure 10: Equity growth curves for skew-arbitrage trading strategies on GOOG options.30% 28.8% -0. Hit Avg.65 5. This strategy also enjoys a reasonably strong hit-rate. Right: Positions taken each day are weighted according to residual magnitude. that there is considerable strategy performance improvements to be gained by implementing the residual-weighted strategy over the simple equal-weighting scheme.5% trading strategy on GOOG. which trades the smallest options volumes of the three studied. the average win and loss are also considerably larger.88% in late 2008 bankrupts the equally-weighted strategy.88% 52. but also the other two options markets presented.1. the weighted strategy provides both a high information ratio and minimal maximum drawdowns over the back-test.Table 3: Performance statistics for volatility skew-arbitrage Max. 3. while the residual-weighted strategy actually produces strong positive returns over the same period. Rate Win Loss 52.2% 2. Finally. Table 3 summarizes the performance statistics for the volatility skew-arbitrage strategies on GOOG.4 Distribution of Returns & Understanding Skew Arbitrage Performance The distribution of residual-weighted volatility skew-arbitrage trading for each of the three options markets discussed are shown in Fig. It is evident from this case in particular. once again suggesting there exists correlation between the depth of the market and the extent to which inefficiencies in volatility skew are tolerated by market participants. As expected based on the equity curve. These plots show a histogram of returns for each individual position taken by the algorithm (rather than the distribution of daily 14 .68% 2.43 100% 32. 11. Avg. Left: Positions taken each day are weighted equally.

11. by diversifying the strategy among many different securities. based on total volume. respectively. diversification substantially improves the performance of this strategy. Proceeding from left to right. the returns are shown in order of decreasing depth of market. Middle: AAPL. Moreover.2 Portfolio Construction and Risk Management In order to reduce the overall risk of the volatility skew-arbitrage trading strategy. 3. the overall capacity will increase substantially. for AAPL and GOOG options in the middle and right. The AAPL and GOOG distributions are also significantly wider indicating the larger variance of returns for these two cases. show that the mode is either near zero or perhaps slightly biased in the negative direction. strong positive returns are observed throughout the test time. indeed. and 2) A portfolio that invests assets equally across SPY. which leads to lower information ratios. Results from the back-tests of these two strategies are shown in Fig. Left: SPY. However. occurring during periods of market turmoil. shown on the left. this assumption is incorrect as evidenced by this data. GOOG. are narrowly distributed between ±2%. Two different configurations were tested: 1) A portfolio that invests assets equally in SPY and GOOG. The returns from SPY. In both cases.returns). Right: GOOG. Figure 11: Distributions of returns for residual-weighted volatility skew arbitrage strategy. Table 4 shows statistics on each of these portfolios. These results suggest that. In Fig. 14. As mentioned previously. Although including AAPL options in the portfolio reduced the 15 . and AAPL. 11. the return distribution is spread out over a larger range corresponding to these market depths. Initially it was suspected that the first configuration would produce superior results due to the lackluster performance of the volatility skew arbitrage strategy on AAPL options. with a visible bias of the mode towards the positive direction. we can also see that the returns are distributed over a wider range of values inversely proportional to the depth of the options market in a particular security. are still plainly evident. The other two plots in Fig. portfolios of combinations of securities were studied in order to investigate whether there would be significant diversification benefit from investing the strategy in multiple markets simultaneously. although the strongest trends.

Hit Rate Portfolio Total Return Information Ratio Days Traded SPY + GOOG 147% 0. Finally. you can see that none of the model specifications we ran had a hit percentage over 50% which does not seem promising. and if they didn’t both move in the same direction it was a ”miss”. we considered that a ”hit”. They also almost all had the same 16 .52 40% 53. we took each type and. To test how well each model specification worked. Table 4: Performance statistics for volatility skew-arbitrage trading strategy portfolio of multiple securities. Right: SPY.91 58% 54. and AAPL. From this figure. and compared that to how the volatility actually moved going into the next period. and also produced a significant improvement in the number of days traded.3 Time-Series Predictors There were multiple different specifications on the GARCH and EGARCH models that we tested when trying to determine which would best be able to predict future volatilities. which will help to smooth returns over a shorter period of time. If the predicted volatility was a shift in the same direction as the actual volatility movement. 3. We then checked to see if the predicted volatility was higher or lower than the actual volatility on the last period. it dramatically increased the information ratio. After each fit. which is a strong enough result to be considered for practical use. we used the new model to predict the next period’s volatility. it also improved the hit rate to over 54%.9% SPY + GOOG + AAPL 134% 0. The hit percentage for a handful of GARCH and EGARCH models that we tested can be seen in Figure 13. over each of the last 200 observations.Figure 12: Back-test returns of volatility skew arbitrage strategy on a portfolio of different securities (equally-weighted between each security). GOOG. Left: SPY and GOOG. refit the model by each period.2% total return.

are shown in Figure 14. so it is hard to tell which specifications might be better than the others and merit further research more than the others. On a brighter note. A graph of the cumulative returns.Figure 13: GARCH and EGARCH models and their Hit Percentages hit percentage.2) through the same trading strategy that was used to determine the profitability of the skew arbitrage strategy. Figure 14: Histogram of returns and graph of cumulative returns for EGARCH(1.1) with ARMA(2. but it did make some money. We only made a little under 5% over the course of about two and a half years. these models did show promise in being able to model and predict future volatilities. when we ran the EGARCH model with specification (1.2) Although returns were low and hitting percentages slightly below 50%.1) and return ARMA specification of (2. even though none of the models have a hit percentage over 50%. along with a histogram of returns. we did make money. possibly using a different time scale than 5 17 . With this in mind. we do think that they merit a deeper looking into.

M. pp. pp. Kluwer Academic Publishers. filter. Horst and P. SFB 649. Borland. Option Pricing Formulas Based on a Non-Gaussian Stock Price Model. this class provided us with a unique opportunity to go through an iteration of the entire process. we hope to test this strategy on more underlying securities and perhaps use portfolio optimization or dynamic programming techniques to more concretely extract diversification benefits in constructing our blended portfolio. Furthermore. and visualize options data for several different underlying securities and then back-test three different options trading strategies on them. SFB 649 Discussion Paper No. Luenberger. we were able to procure. which seems to be a more accurate representation of industry practice. 81. (2014). 217270. we found varied success in the multitude of strategies we explored. 18 . While this strategy provided less impressive results on GOOG and AAPL. Handbook of global optimization. L. (2005a).days for the volatility or on a series of data that has more than 536 points on it. Our residuallyweighted arbitrage-free spline fitting strategy on the SPY provided us with the most promise as a potential participant in a regime-switching strategy. in R. 89. Arbitrage-free smoothing of the implied volatility surface. C. we believe with more analysis and refinement we could improve upon them in hopes of including them in our blended portfolio.. A. References Black. The Pricing of Options and Corporate Liabilities. F. 637-654. V. 374-442. M. Although our time-series modeling back-tests were not compelling enough to make the strategy actionable currently. Pardalos (eds). and M. we were given the freedom to pursue newer ideas that we found intriguing while also learning more about commonplace volatility modeling techniques. we saw some diversification benefits from their inclusion in a blended portfolio with SPY. 4 Final Thoughts and Future Work In all. Investment Science. Going all of the way from data procurement to analyzing strategy results gave us valuable experience in forging and executing a full cycle of a quantitative trading strategy. Fengler. Physical Review Letters. Floudas. Dordrecht. Humboldt-Universitt zu Berlin. While many other classes probably focus on specific parts of this cycle. pp. Scholes (1973). D. In the future. In summation. Quadratic optimization. (1995). (2002). 2005019. and Viswewaran. Oxford University Press. Journal of Political Economy.

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