Index option trading with statistic (2)

In my earlier post I mentioned an idea of index option trading with a database which provides statistical information for trading decision. Naturally there are many analysis one has to make in option trading in order to be profitable, or at least, to stay safe because option trading involves leverage. It could be catastrophic if the market goes against one's position.

When narrowing down all the decisions, it indeed just comes down to two key ones, ie., the strike picking and the timing for opening a position. This is when a database of the past trading statistical info could be helpful.

The rationale of the application of database in index option trading rests on two assumptions, ie., 1) the index intra month fluctuation and particularly the monthly settlement point are the outcome of the combat between the big bullish players and the bearish counterparts and 2) the past scenarios, in a certain extent, will repeat in the future. If we believe these two points hold true then we can refer to the database of past record for some inference on the two key decisions, ie., strike picking and timing.

For the short side traders, a safe strike is at OTM level when opening a position and this strike will still stay below the settlement point in case of short put (will stay above the settlement point in case of short call). Ideally when opening a position the more OTM away from the prevailing index point the safer. However, the drawback of a too OTM strike is that the premium received is too little which might not be justified the potential risk in a volatile market situation. So in my previous post I raised an example of a strike which has a only 0.10 probability that settlement point might go beyond it. In other words, it means 90% of chance the positions are safe at the settlement day despite the index could run beyond the position strike in case it approaches to the month's peak (in case of short call) or the month's low (in case of short put) but the settlement will eventually be below(above) the strike of the short call(short put) position. 10% probability is only an example so one can choose his risk exposure by adjusting the percentage of probability to suit his risk appertize.

A strike with only 10% of chance being struck through is only a conception however one has to work out at what exact strike in the trading execution in each month. In such case we need a database of  trading records in the past months, the more the better. Unfortunately there seems no such database readily available in the market so one must build it by his own. I started building my own database a few years back and have been refining it over the years since then. It covers the past trading data since 2000 September. This is the oldest month which I can get the trading data so far. In the database and among all data, the most important trading data are the rollover point and the settlement point for each month. I need these two figures to work out how far the settlement point is away from the rollover point in each month so that I can get the monthly deviation. These monthly deviations play an important part in the safe strike picking.


According to my database, among the past 18 years, the biggest deviation in HSI on the upside is +5138 point in 2007 October and the downside is -4832 point in 2008 October. However 90% of chance the deviation lies between +1784 points for the upside and -2233 points for the downside comparing to the rollover point. For example the HSI index rollover point from last June to this July is 28601 so one can reasonably expect a 90% safe strike at 304 for short call and 264 for short put provided there will be no black swan events within this month.

When a database is built then working out the 0.10 failure probability strike is relatively easy. The Percentile function in Excel can easily give you what the relevant strikes corresponding to different given probability are like based on the deviation info in the past months record from the database.

Despite my database just includes nearly 18 years record yet luckily it covers three waves of market up trends and two waves of downtrends respectively so it should be representative enough for both uptrend and downtrend market inference.


Having mentioned many times of strike with 0.10 failure probability but one must bear in mind such failure probability means in average over the long run one failure out of ten trades so one must decide whether 90% chance safe is good enough for self. On the other hand despite 90% of trades will see the settlement point be well contained within the strike but the index could likely go beyond the strike prior to the settlement day so heavy margin liquidity could be required during this period prior to the settlement day. Naked short position will see heavy pressure on the margin requirement to keep the position alive and it could be extremely painful. Therefore protective long or certain types of hedging is highly recommended for sleeping well at nights.

This is a rather long post so I am going to talk about the timing for position opening with database in next post. Tentatively I called this index option trading with database statistical record as Probability Trading because decisions rest mainly on the probability of how likely an event will or will not occur.