By Barry L. Star, CEO of Wall Street Horizon
Options remain the closest community of market participants, and the murkiest. Even to its veterans, the options market can seem uncanny; its trading has always been full of mystery. Rumors abound of big-wins and equally huge losses turning on a dime, and there is common sleight of hand. It evolves at its own pace. But wild swings and tectonic shifts can also be born of simple mistakes. Such was the case in 2015, when a pair of microprocessor manufacturers was first reported to be in merger talks[i]. In only a few seconds, the news quietly generated a sizable option contract on one of the companies’ stock prices. Initially costing around $110,000 for more than 300,000 shares, the option went from completely out of the money to worth $2.4 million in less than half an hour.
The reporting subsequently proved wrong, adding intrigue and furrowing eyebrows. But in the end, it wasn’t the windfall or the scant information that turned out to be significant; rather it was the speed. The option, most observers agreed, could only have been generated by an algorithm—an incredibly fast one, at that. While neither the first nor certainly the last, this was some of the most dramatic public evidence yet that low-latency and high-frequency trading (HFT) techniques had arrived—and for that matter, could work—in a space where they had only been casually embraced before.
Below we explore new trends in the development of event-based trading signals in the equity options market. Ultimately, we conclude that investors must construct a dual strategy—combining measurable post-trade execution quality analysis with pre-trade contextualized indicators of price movements—to effectively mitigate downside risk and exploit market inefficiencies with options.
The Challenge: Reading Corporate Tea Leaves
The growing cohort of investors represents a kind of ‘Goldilocks’ group of options participants. They are compelled to be able to execute in a few seconds, but without the need or wherewithal to move in microseconds. In short, timing matters. Equity options provide an effective way to play on ideas about a listed company’s price—be they changes in market sentiment one way or other, or mitigating short-term volatility. There are myriad ways to construct that option position, from simple binaries up to multi-strike butterflies and other wingspread strategies. Either way, doing so inevitably starts with the target strike (or strikes) and tenor for the option.[ii] And they often focus in upon a corporate[iii]event.
This exercise requires context—placing a premium on availability and the proper application of data.[iv] Key characteristics of an option are shaped by isolating phenomena and information that drive changes in the underlying stock’s price. Indeed, some of the data points surrounding an event can be highly diverse, and at times hard to find. Their impact and relevance will be open to debate and, like the microprocessor merger mentioned above, crucial signals about the direction can sometimes come out of nowhere, or prove inaccurate.
Still, many scheduled corporate events can be planned for and actively monitored in advance.[v] Empirical research has shown this corporate “body language”—changes and modifications to the calendar and even the structure of the news, itself—can even provide accurate, predictive signals as to the future state of the company’s health.[vi] These data points, whether public or primary sourced, can be absolutely crucial if timely and properly structured, verified for accuracy and populated into the strategy. They are essential tea leaves about corporate behavior and future performance of an equity; yet until recently, many investors have been slow to read them.[vii]
There are at least two applications where this data should be applied – corporate earnings calls and disclosure of dividends distribution have significant consequences for pricing, and their timing is fairly predictable. Studies using corporate event data have proven that the nature of the news—positive or negative relative to expectations—can be accurately surmised from changes in calendaring of these events.[viii]
Deploying faster electronic execution enables firms more time to precisely game out these events, take heed of ongoing price movements[ix]and optimize construction of the option without crossing the spread. Of course, it also allows HFT, low-latency firms and market makers to do the same, swooping in when orders increase around an event to pick off slower flow. Some of the challenges that result from this asymmetry are very complex. For example, correctly structuring sensitivities in multi-strike spread strategies, and aligning the cost of the option against the investor’s level of tolerable risk, are all the more difficult to do in a market where faster players might be lurking.
With the right data, other defensive challenges are more easily solved for. This can be as straightforward as missing a change in the timing of the earnings call; likewise, there may be mistaken reporting or even a misdated announcement from the company, itself. Changing dividend amounts and calculated payouts—or the suspension or resumption of a dividend—frequently present another, similar issue of timing. A revised dividend will likely modify an equity’s Sharpe ratio (risk-free versus risk-adjusted returns). Depending on the portfolio’s risk management tolerances, that may artificially skew—and typically, limit—the types of options that can be used.
Rearguard Action: Data Feed Requirements
Neither of these problems—misplacement of the contract’s tenor, or an incorrect strike—is unique to an HFT environment. However, they are far more likely to be punished. Likewise, firms that can prove out their defensive techniques are more likely to be able to use that same logic, venue knowledge, and technology in reverse. Even if they cannot move quite as quickly as the top players, concerted investment in this area might just provide two new tools for the options arsenal.
How to do it? Faster execution capabilities are unavoidably important; yet a more complete rearguard action requires building competencies around event data—sourcing it, qualifying its accuracy, digesting it, and putting it into action in a low-latency setting.
The other component—predictive analytics that compare patterns of corporate behavior leading up to events against a stock’s “point in time” pricing—is more qualitative in nature and trickier to develop internally. An earnings date that seems askew or payout that appears completely unachievable cannot be evaluated for its veracity without context—which requires filtering tools and curation. Vetting these signals requires not only machine-readable news and natural-language processing elements to discover them (often but not limited to press releases), but extensive warehousing of data to reference and intuitive sentiment analysis guiding the output.
Options trading was once a technologically sluggish, space. Expectations were low because, besides occasional murmurs of a big play or a big flop, it was as much a testing ground for theory as it was a good way to hedge or short. For better and worse, the arrival of higher speeds has changed all that.
Today, amongst this louder din of high-frequency and lower-latency trading, there is a natural and understandable twitch to try and catch up—to join the herd mentality. For the many participants in the middle, though, to whom that seem a losing proposition, we suggest an alternative approach: a focus on the calendar—not the microseconds—and a mastery of reading for mistakes. Mistakes can include inaccurate dates as well as content and both need to be considered. Then as you increase the speed of the transaction and combine it with accurate data, you achieve an overall better deployment of the data. With a prior back-testing of your strategy, and an ongoing evaluation of your execution quality, your analysis and subsequent transactions should enable you to mitigate downside risk and exploit market inefficiencies with options.
How has the online trading landscape changed in 2020?
By Dáire Ferguson, CEO, AvaTrade
This year has been all about change following the outbreak of coronavirus and the subsequent global economic downturn which has impacted nearly every aspect of personal and business life. The online trading world has been no exception to this change as volatility in the financial markets has soared.
Although the global markets have been on a rollercoaster for some time with various geopolitical tensions, the market swings that we have witnessed since March have undoubtedly been unlike anything seen before. While these are indeed challenging times, for the online trading community, the increased volatility has proven tempting for those looking to profit handsomely.
However, with the opportunity to make greater profits also comes the possibility to make a loss, so how has 2020 changed the online trading landscape and how can retail investors stay safe?
Interest rates offered by banks and other traditional forms of consumer investments have been uninspiring for some time, but with the current economic frailty, the Bank of England cut interest rates to an all-time low. This has left many people in search of more exciting and rewarding ways to grow their savings which is indeed something online trading can provide.
When the pandemic hit earlier this year, it was widely reported that user numbers for online trading rocketed due to disappointing savings rates but also because the enforced lockdown gave more people the time to learn a new skill and educate themselves on online trading.
A volatile market certainly offers great scope for profit and new sources of revenue for those that are savvy enough to put their convictions to the test. However, where people stand the chance to profit greatly from market volatility, there is also the possibility to make a loss, particularly for those that are new to online trading or who are still developing their understanding of the market.
The sharp rise in online trading over lockdown paired with this year’s unpredictable global economy has led to some financial losses, but with a number of risk management tools now available this does not necessarily have to be the case.
Protect your assets
Although not yet widely available across the retail market, risk management tools are slowly becoming more prevalent and being offered by online traders as an extra layer of security for those seeking to trade in riskier climates.
There are a range of options available for traders, but amongst the common tools are “take profit” orders in conjunction with “stop loss” orders. A take profit order is a type of limit order that specifies the exact price for traders to close out an open position for a profit, and if the price of the security does not reach the limit price, the take profit order will not be fulfilled. A stop loss order can limit the trader’s loss on a security position by buying or selling a stock when it reaches a certain price.
Take profit and stop loss orders are good for mitigating risk, but for those that are new to the game or who would prefer extra support, there are even some risk management tools, such as AvaProtect, that provide total protection against loss for a defined period. This means that if the market moves in the wrong direction than originally anticipated, traders can recoup their losses, minus the cost of taking out the protection.
Not a day has gone by this year without the news prompting a change in the financial markets. Until a cure for the coronavirus is discovered, we are unlikely to return to ‘normal’ and the global markets will continue to remain highly volatile. In addition, later this year we will witness one of the most critical US presidential elections in history and the UK’s transition period for Brexit will come to an end. The outcome of these events may well trigger further volatility.
Of course, this may also encourage more people to dip their toes into online trading for a chance to profit. As more people take an interest and sign up to online trading platforms, providers will certainly look to increase or improve the risk management tools on offer to try and keep new users on board, and this could spell a new era for the online trading world.
By Paddy Osborn, Academic Dean, London Academy of Trading
Whether you’re negotiating a business deal, playing a sport or trading financial markets, it’s vital that you have a plan. Top golfers will have a strategy to get around the course in the fewest number of shots possible, and without this plan, their score will undoubtedly be worse. It’s the same with trading. You can’t just open a trading account and trade off hunches and hopes. You need to create a structured and robust plan of attack. This will not only improve your profitability, but will also significantly reduce your stress levels during the decision-making process.
In my opinion, there are four stages to any trading strategy.
S – Set-up
T – Trigger
E – Execution
M – Management
Good trading performance STEMs from a structured trading process, so you should have one or more specific rules for each stage of this process.
Before executing any trades, you need to decide on your criteria for making your trading decisions. Should you base your trades off fundamental analysis, or maybe political news or macroeconomic data? If so, then you need to understand these subjects and how markets react to specific news events.
Alternatively, of course, there’s technical analysis, whereby you base your decisions off charts and previous price action, but again, you need a set of specific rules to enable you to trade with a consistent strategy. Many traders combine both fundamental and technical analysis to initiate their positions, which, I believe, has merit.
What needs to happen for you to say “Ah, this looks interesting! Here’s a potential trade.”? It may be a news event, a major macro data announcement (such as interest rates, employment data or inflation), or a chart level breakout. The key ingredient throughout is to fix specific and measurable rules (not rough guidelines that can be over-ridden on a whim with an emotional decision). For me, I may take a view on the potential direction of an asset (i.e. whether to be long or short) through fundamental analysis, but the actual execution of the trade is always technical, based off a very specific set of rules.
To take a simple example, let’s assume an asset has been trending higher, but has stopped at a certain price, let’s say 150. The chart is telling us that, although buyers are in long-term control, sellers are dominant at 150, willing to sell each time the price touches this level. However, the uptrend may still be in place, since each time the price pulls back from the 150 level, the selling is weaker and the price makes a higher short-term low. This clearly suggests that upward pressure remains, and there’s potential to profit from the uptrend if the price breaks higher.
Once you’ve found a potential new trade set-up, the next step is to decide when to pull the trigger on the trade. However, there are two steps to this process… finger on trigger, then pull the trigger to execute.
Continuing the example above, the trigger would be to buy if the price breaks above the resistance level at 150. This would indicate that the sellers at 150 have been exhausted, and the buyers have re-established control of the uptrend. Also, it is often the case that after pause in a trend such as this, the pent-up buying returns and the price surges higher. So the trigger for this trade is a breakout above 150.
We have a finger on the trigger, but now we need to decide when to squeeze it. What if the price touches 150.10 for 10 seconds only? Has our resistance level broken sufficiently to execute the trade? I’d say not, so you need to set rules to define exactly how far the price needs to break above 150 – or for how long it needs to stay above 150 – for you to execute the trade. You’re basically looking for sufficient evidence that the uptrend is continuing. Of course, the higher the price goes (or the longer it stays above 150), the more confident you can be that the breakout is valid, but the higher price you will need to pay. There’s no perfect solution to this decision, and it depends on many things, such as the amount of other supporting evidence that you have, your levels of aggression, and so on. The critical point here is to fix a set of specific rules and stick to those rules every time.
Good trade management can save a bad trade, while poor trade management can turn an excellent trade entry into a loser. I could talk for days about in-trade management, since there are many different methods you can use, but the essential ingredient for every trade is a stop loss. This is an order to exit your position for a loss if the market doesn’t perform as expected. By setting a stop loss, you can fix your maximum risk on a trade, which is essential to preserving your capital and managing your overall risk limits. Some traders set their stop loss and target levels and let the trade run to its conclusion, while others manage their trades more actively, trailing stop losses, taking interim profits, or even adding to winning positions. No matter how you decide to manage each trade, it must be the same every time, following a structured and robust process.
The final step in the process is to review every trade to see if you can learn anything, particularly from your losing trades. Are you sticking to your trading rules? Could you have done better? Should you have done the trade in the first place? Only by doing these reviews will you discover any patterns of errors in your trading, and hence be able to put them right. In this way, it’s possible to monitor the success of your strategy. If your trades are random and emotional, with lots of manual intervention, then there’s no fixed process for you to review. You also need to be honest with yourself, and face up to your bad decisions in order to learn from them.
In this way, using a structured and robust trading strategy, you’ll be able to develop your trading skills – and your profits – without the stress of a more random approach.
Economic recovery likely to prove a ‘stuttering’ affair
By Rupert Thompson, Chief Investment Officer at Kingswood
Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.
As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.
Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.
We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.
Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.
Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.
China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.
Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund. As is almost always the case, a messy compromise will probably end up being hammered out.
An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.
Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.
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