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Comment by mbroshi | Hacker News Reader

I wonder whether the premise of your question is faulty. If you ask enough people: "In your last 100 flips of a coin, did you get more than 60 heads?" some will truthfully say "Yes." Unfortunately, that does not mean there's anything special about their coin-flipping strategy, or that you will be able to generate a successful coin-flipping strategy.

My guess is what you really want to know is "What is my expected gain if I try to employ an algorithmic trading strategy?" I have my suspicion of the answer to that question, but I don't believe your current question will shed any light on the answer.

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Mostly I believe this too, but I am familiar with some people who can consistently make money year after year. From talking to them it becomes clear that they understand things very, very deeply.

See /u/Fletch71011 on reddit-- he's always happy to discuss things. He's made millions trading options, mostly algorithmically as I've understood it. The methods he uses are sufficiently complex that you need to be very well acquainted with the intricacies of derivatives to follow along, but basically he trades volatility instead of price movement. Regardless of whether the price of the asset goes up or down, he makes money. In his opinion, it's foolish to try to trade price direction, and you're basically flipping coins and likely to lose money.

I tried understanding what he was doing and abandoned the attempt. I had to conclude I was not quite so clever as he.

I am not sure I understand this.

It takes just as much skill to guess if volatility will go up or go down as it does to guess if prices will.

The best models we know of (say GARCH) will still pace the information in the option prices.

A key part of how options premiums are priced is the expected, or implied volatility (IV) of the underlying (the stock/future/whatever). Therefore you can be an options seller (selling calls and puts) to get high premium, expecting that before the options expire, the IV of the underlying will decrease, making it more likely you can keep the credit received from selling those high-IV priced options. It can also be historically shown that the IV for any underlying is about 75%-80% of the time overestimated, in which the price of the underlying turns out to not be as volatile as what was suggested by the IV.

But 20-25% of the time it is more than 3x as volatile. Taleb built his career on this.

Markets have been going up for a while now. So anyone with half a brain is making money. But long term, there are essentially 0 investors making money on day or algorithmic trading.

That's extremely untrue. Especially if we are counting non-retail investors i.e. prop market maker trading

Be careful with volatility. I don't know what he's trading on exactly. But a big part of volatility trading is selling insurance, i.e. selling insurance against the direction of S&P. You can make a lot of money collecting insurance premium, but on the event of a payout, like a sudden big drop in S&P, the loss can be very substantial. See XIV and SVXY in February of this year.

Trading volatility might imply that he's buying options in both directions.

Big moves either up or down would be profitable. The only unprofitable move here would be no substantial moves in either direction. (In which case you lose your entire bet, but no more.)

> Big moves either up or down would be profitable.

The problem is that much more often than not the “only unprofitable move” is the one that happens. Options in general are too expensive and that’s why selling “insurance” is profitable most of the time. Maybe he can identify consistently mispriced vol, though.

> Maybe he can identify consistently mispriced vol, though.

This was the method I used, as described in another comment.

Very interesting, thanks for the pointer.

Could you expand on how that would work? If X is priced at 10 units of currency, and I promise to buy 1 X for 11, and to sell 1 X for 9. And X stays available for 10, I end up paying 11, receiving 9 - netting a loss of 2. If I manage to promise a sell/buy at 10, I even out. What do I lose with low volatility? And how do I make money "both ways"?

Clearly I lack a basic understanding of the concepts involved.

In volatility trading you don't cary naked options (you hedge them usually dynamicaly - readjusting hedge every now and then) and usually close positions before options expire. So your analysis does not apply. If you want to get understanding on how to trade volatility the "Volatility Trading" by Euan Sinclair is excelent.

"Volatility" in the term "Volatility Trading" does not mean the stock's movements, it is a way of measuring the excess value in an option beyond what the parameters of the option would imply. That excess value is usually referred to as the market's assumption about the future volatility of the stock, but really its just an error term influenced by market participants based on supply and demand. Low volatility means "pretty close to its theoretical value assuming no volatility" or to put it another way: "cheap" i.e. good for buyers and bad for sellers.

Sort of like how different companies with the same cash flows can trade at different multiples, otherwise identical options in two companies (or different expirations/strikes in the same company) can trade at different prices because of the opinions of market participants. Volatility traders act when the different prices/error terms are too far apart, counting on the prices/error terms to converge a.l.a. pairs trading.

Since they are trading the error term directly, they attempt to construct positions that remain relatively flat in value as the stock moves around, but are designed to only change in value when the error term changes. That is how they can make money "both ways", because they can profit if the stock goes up, down, or stays the same, as long as the error term moves in the correct direction.

The reason you only see sophisticated people doing this kind of trading is because you need a large and complex position with many hundreds of options to be in a truly market-neutral environment. You can't take advantage of mispricing without such a large position because buying/selling single options involves a tremendous amount of risk, so you need to do that as a part of a larger portfolio to spread that risk. Retail traders tend to spread the risk by doing 2 transactions (the mispriced option and a well-priced but mirrored hedge option), but that is a) much more expensive from a commissions standpoint and b) really limits the range of market-neutrality forcing you to adjust more frequently to stay market-neutral, again, with commission costs.

So it's "buy low, sell high" - but for options, not stocks?

[ed: that's to say, you need a way to get more/accurate pricing information than reflected in the market - but for options, not assets]

Yes, this is how the guy I was referring to explained it to me~ he created a pricing model to predict errors/inaccuracies in the market's model, and was thus able to know when an option was likely to move towards a different price to correct itself.

Yes, but its sort of changing the definition of high and low from price (with stocks) to volatility (with options) and having the expertise to trade volatility like that without _accidentally_ trading on price.

I think the terms you're looking for are "straddle" and "strangle" options strategies.

If I recall correctly, your structure describes a future not an option.

If you buy put options for X at 10, and call options for X at 10, then if the price moves down you exercise the call option, and if the price goes up you exercise the put. Unless the price is totally fixed, you make some profit. The real question is whether this profit outweighs the price of both your options.

You need the price to move sufficiently for this plan to be worth it. Especially because in any case, either your put option or your call option is worthless. Thus, you need twice as large a price move as when buying only puts or calls. The upside is that you don't need to care about the direction of the movement.

Khan describes the long straddle (3:53): https://youtu.be/2HIRaOQDRho

The common strategies are delta heding, gamma hedging and gamma scalping for market neutral trades.

if you delta hedge (ie taking opposing positions in the underlying and the derivative, ie selling a call and buying the stock and then constantly readjusting your position), you can protect yourself against small / normal changes in price of the underlying, but if there are big jumps in the underlying, and acceleration of delta (ie gamma) you can lose a lot.

On a per equity basis there are reasonably consistent ways to predict near term volatility using sentiment analysis and revenue forecasting ("alternative" data). I would not attempt this with something like the VIX, but for selling options on individual equities it can work.

A 50% chance to lose money per year still allows for very long strings of success. Some strategy's trade ~80% chance of a small win for a ~20% chance of a large loss which means lucky streaks could last for decades.

So, basically you are saying that it's all gambling and nobody has a better strategy / better information than everybody else. Some are just lucky and it is all because of the survival bias.

I agree with you in that it is a possible explanation, but I disagree in that it is the only one possible.

I feel that what he's saying is that it's hard to tell if somebody actually has a working strategy or it's just gambling, they can be nearly indistinguishable, and (given the number of people) someone showing a streak of successes is really not much evidence that it's something beyond luck.

They may have something, but since you can't determine if it's so and there is a lot of just gambling, then most likely it's that.

That's part, but the reverse is also true. Someone could lose money and still have better odds than normal. Something like skill adds 5% then luck adds or removes 30%.

I didn’t gather that from what he said at all, personally. I interpreted his comment at face value; it is possible to pull a profit over an arbitrary period of time even with 50/50 odds.

As a former vol trader, I think this is possible. I have friends who were former pit locals and are now sitting at home trading options.

It is all moving to algos, though.

With vol it's one of those specialized areas where it's probably quite hard to learn without having sat on an options desk. Even the way it's presented in the books does not give a good picture of what you're supposed to do.

Its not that complicated, he mentioned using off-the-shelf software, there just aren't a lot of retail traders who can open an office in the CBOE and hook directly to the exchange computers while running enough contract volume to essentially make markets.

I think your argument is logically correct, but you are using numerical assumptions that are off by one or two orders of magnitude. Your typical successful algorithmic trader is probably flipping their metaphorical coin 1,000,000 times, and getting 520,000 heads. Each individual trade may only be slightly profitable, but there is often no statistical ambiguity about the effectiveness of the strategy.

Individual trading strategies often become less effective over time, though. Whether this kind of success can be sustained at the level of a trading firm over many years is an entirely different question. Whether they can beat the market after fees is a third, also entirely different question.

> "What is my expected gain if I try to employ an algorithmic trading strategy?"

The market is negative sum, so any abstract strategy has an expected excess return which is negative. It should be everyones assumption without competing evidence

Algorithmic strategies include such gems as "buy on mondays and sell on thursdays", and there is no inherent magic to them making them better than my "buying stocks with names I like".

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