Mean reversion options trading
Many of the strategies traders use fall into one of the following categories: The challenge with any momentum play is, of course, knowing when to get out. A Tendency, not Just a Trade The most important thing to realize about any strategy that relies on mean reversion is that you are looking for a relative edge, mean reversion options trading absolute success on each trade.
In other words, if a mean reversion trade goes bad, it can go very, very bad, so some pre-defined risk level is absolutely necessary. Identifying Mean Reversion Opportunities Finding good mean reversion opportunities is straightforward: Here are some rules for a very basic but effective mean reversion strategy: Note the mean reversion options trading high and low of the prior week.
Exit the trade 7 days later or when a new signal is generated, whichever comes first. Now, this is obviously just one strategy among many you mean reversion options trading use. Nor should you restrict your research to price levels alone — viable strategies can be developed using moving averages and Bollinger Bands, for example. Our exit criterion is also somewhat arbitrary; performance is robust across shorter and longer holding periods.
Notice that we allow for new signals to reverse our exposure; however, the average holding time per trade was still 6. As for the question of mean reversion options trading underlyings to use, we prefer to use indexes or ETFs that track a particular industry, index, or country in order to avoid the surprises that often come when dealing with individual stocks or commodities. The attached chart simulates a mean reversion options trading portfolio that sat in shares of SPY since inception, versus a portfolio that goes long or short shares of SPY per the signals described above.
We did not factor in any transaction costs or interest on cash. Two Option Strategies for Trading Mean Reversion The reason we would want to trade options on the basis of these mean reversion signals is twofold. We can put the difference in a risk-free interest-bearing asset. Secondly, mean reversion options trading more importantly, we want to use options to improve the performance of the strategy. Because options have exposure to changes in volatility and to the passage of time, they offer profit opportunities above and beyond the mere directional changes in the underlying.
Here are two ways we might use options to trade mean reversion signals: A Sell out-of-the-money OTM vertical spreads. This approach consists of selling one OTM option, and buying an even further OTM option to define risk and hedge the trade.
We could have sold the following spread: Notice that we chose strikes at andleaving a ten point buffer zone between the underlying and the short strike of our trade.
Mean reversion options trading way, even if the underlying moves against us, we will still be profitable as long as SPY is lower than In this case, SPY moved lower immediately, and closed at November expiration at You may have noticed that a long signal was generated on November mean reversion options trading, with SPY at At November expiration, SPY closed just a hair under the breakeven point on that trade, making it a small loss; but the two options spreads together were solidly profitable over this period, versus a loss of 3.
B Buy at-the-money ATM puts. If an underlying moves high enough to generate a sell signal for this strategy, chances are that implied volatility may have declined over the very short term enough to make put options cheap on a relative basis. If the trade is successful and the underlying moves back down into its prior range or lower right away, put owners would stand to profit both from directional exposure and from an increase in implied volatility.
With SPY at Mean reversion options trading implied volatility tends to correlate negatively with price movement, buying calls in anticipation of mean reversion to the upside mean reversion options trading often entail overpaying for those options and realizing smaller gains — even on a very directionally successful trade — due to declining volatility premium. Conclusion The mean reversion strategy tested above is just one example of broader market tendency. Our aim has been to show that a a mean reversion strategy can outperform a buy-and-hold approach over the course of a market cycle, and b that traders can use options to improve the performance and reduce the risk of such strategies.
Jared Woodard is the principal of Condor Optionsa New York-based research and trading firm focusing on market neutral trading strategies. Mean reversion options trading Options publishes educational newsletters teaching iron condors, calendar spreads, and volatility-based options trading with a focus on risk management and quantitative analysis. At Connors Research, we are using it as an overlay to many of our best strategies to make them even better -- now you can, too. The Connors Group, Inc.
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