Index option trading with statistic (3)

In my previous post with the same heading I mentioned an idea of trading index option based on the probability as a result of a database. I called it Probability Trading because trading decisions refer to the probability of relevant event regarding a particular sorting result.

In the last post I said one could reasonably expect the July HSI option settlement point to rest between304 and 264. The exact settlement point was 28644, just 44 points above the rollover point. This is a very small deviation from the rollover point. With the same principle, the expected settlement point should lie between 306 and 266 for this month August. August should see a bigger volatility because the trade war tension intensifies.

In the first post of this topic I mentioned that a database is good for strike picking as well as the timing of position building. Every option traders know that apart from picking a suitable strike timing also plays a crucial element in option trading. Indeed it could be the key factor of profitability or even between the make or break due to the time value decay property of option.

When we talk about timing in option trading, there are mainly two key aspects, ie., which type of position, ie., long or short, is more appropriate for the different phases in a particular month if we break it into three phases namely the beginning, middle and the end of a month. The other aspect of the timing is about exactly when the position should be built. All seasoned option traders know that generally speaking long position is better built in the beginning of a month then to close it before the middle of the month when time value starts to shrink rapidly in an accelerated rate day after day while the short side position contrarily can be benefited from this phenomenon. We do not need a database to know this.

For the second aspect, ie., the exact timing to build a position, is mainly for the short side because short position, once built, is always exposed to the index movement that goes against the position which leads the position subjected to a heavy increase on the margin requirement. So the effort in the attempt to build the short position after the intra month's peak or bottom is highly desirable. This is when a database could provide some insight over the past records.

If we break down a month into three phases, the first 10 days as phase 1, 11th-20th day as phase 2 and the remaining days as phase 3. Depending on the sequence of the month's high and low, there are 1H3L, 1H2L, 2H3L which are mainly a descending pattern and 1L3H, 1L2H, 2L3H which are in ascending pattern. What a short side trader does not want to see is at any time after building the position but then finds out the peak or bottom is yet to come but will fall into the phase 3, especially when the index will rise above his short call position or will drop below his short put position.

Apparently an early identification of whether a particular month is in descending or ascending pattern is helpful to avoid this situation. On the other hand, a high success rate of guess on which phases the month's H and L will land in could further minimize the chance to fall into the above situation. For example, if a particular month is identified with pattern of 2L3H, short put position is safe to be built only in phase 2 when the month's L has already existed while short call position is always not suitable in that month. Knowing the HL pattern in a month in advance helps a lot on the timing of the short side position building.

However, one will know when the month's H & L happen only when the month finishes so how to identify the pattern before the month ends is vital. This is the time a database can help. By sorting with some parameters, past record reveals the probability of different patterns in a month. Sorted with the parameter of the pattern of the 1st phase, my database can reveal the probability as high as 0.6 for the pattern of 1L3H. That means when one sees that particular signal appears in a particular month, there will be 60% of chance that that particular month could be 1L3H. In such case, the trader has a relatively higher confidence to build his short put position in an earlier stage to enjoy the more time value given. The probability info helps on trading decision so that's why I called this trading method as Probability Trading.

Having said so, the success of probability trading lies on how one builds his own database. The key point is whether or not the database is incorporated with the meaningful parameters that can lead to the reveal of the pattern of a month when sorting. My post on this topic is merely an inspiration on the method but how probability trading is beneficial to any trader largely depends on how one designs his own database which can give the greatest benefit out of it.