I have been trying to figure out how the example provided for forward volatility in Section 5, Unit 2 of the course (mentioned in title) works.
Q1. When is the postion created in this example? On what day??
My ans: on 28-08-2017
Q2. What is the actual position created that is being used to calculate PnL?
Q3. What are the prices at which we have created this position??
My ans: ( signal = +1): Therefore:
Buy far-month Option @ 293.60 Rs. and,
Sell near-month Option @ 226.45 Rs.
Q4. When was the position closed?
My ans: Based on the PnL chart displayed, 21-09-2017 @ the profit of 25.49999 Rs.
Q5. In this example, the 'PnL' for the trade is calculated as the cumulative 'PnL' of each day. I want to know why is this the case?
Q6. Why are we taking profit or loss each day instead of calculating it based on bought/sold price of option at the start and end??
Are we exiting the position each day and re-entering it the next day again? That would be impractical considering brokerage. If not, then there is not point in taking cumulative profits of each day to show the total profit.
Q7. If we consider above position entry and exit points, at the end of 21-09-2017, the position created on 28-08-2017 will be in a loss of
(404.05 - 293.60) + (226.45 - 340.80) = -3.9 (loss of approx. 4 Rs.)
Please let me know if I have made a mistake or I have interpreted this startegy wrongly. This example doesnt convey all the information explicitly.
Hi Amey
please find the details below:
Q1. We get the signal to buy on 2017-08-28. The first position is however created on the next day, i.e., 2017-08-29. You can see code line 3 in cell number 7, that shifts the signal to the next day.
Q2. The actual position is generated after shifting it by one day. The P&L is calculated for each day.
Q3. To know the price at which the position was created, simply check the signal column. If it says 1, check the price corresponding to that column (LTP_near_month, LTP_far_month). In your example, the prices will be, LTP_far_month = 219.70, LTP_near_month = 150.80, for the first trade.
Q4. The position was not closed in this example, since we didn't get a sell signal. You can check this by looking at the last row in the signal column, which still equals to 1.
Q5. What we are essentially doing is, that we calculate the P&L for each day in the pnl column. Then, we plot the same as a cumulative sum, because on a particular day, our profit/loss will be a sum total of all the profits/losses on the previous days, plus the P&L on that day.
Q6. We did this to mimic the behaviour of the trading account. If you were to trade the strategy, your broker at the market close, would show the profit/loss at the end of that day. However, you can identify the bought/sold price of the option at the start and end days and it will give you the same result.
Q7. The position on 2017-09-21, is an open position, which was entered in on 2017-09-12. To calculate the profit/loss, simply take the sum of the pnl column between these two dates.
Hope this helps.
Hi Rishabh,
Thank you very much for your prompt response.
Unfortunately I am still not clear about a few things about this example and this whole startegy in general.
So to make my questions clear, lets consider a scenario with data provided in this example.
Step1. Assume we have EOD (end of day) data on 2017-08-28. So, we currently know LTPs of our option and also for the futures contract.
Step2. Now using this data we compute forward valtility and generate a signal of (+1) on this particular day.
Step3. The signal suggests we should: sell - near_month option and
buy - far_month option.
Question1: When will we open this position?
my ans: At the start of next day. Now assuming we didnt see a gap at the open, our Entry prices for this position would be fairly close to the LTP of 2017-08-28.
Which means our Entry Price for a positon that we created signal for on 2017-08-28 should be fairly close to the LTP of that day even if we opened the position on next day. (Please correct me if I am wrong so far).
So, for this example let us assume the Entry prices are: near month sold @ 226.45 and
far month bought @ 293.6
Step4. Wait for the EXIT signal to be generated.
Step5. On the evening of 2017-08-30, we see a signal of (-1).
Question2: Is this the signal we should use to exit the position created on 2017-08-28??
My ans: Although this shouldv'e been cleared exiplicitly in the strategy, YES.
(Note: This was not clear to me while asking above question hence the doubt regarding 'pnl')
Step6. We close our position on 2017-08-31 day morning. Again, assuming the prices opened without any gap, our closing prices will be fairly close to EOD values of 2017-08-30.
Step7. Calculate PnL using above values.
(226.45 - 191.20) - (293.6 - 259.7) = 1.35 Rs. ( Same value as predicted by the 'pnl' column ----> 1.75-0.4)
Now, I have several questions regarding this whole process:
Q3: In order to enter into such position, how did we decide which strike price to choose. In our example we only talk about a single strike price but in real world, scanning options data in realtime we couldv'e chosen any other strike for that option. So, what are the factors that affect this choice and how do I decide this in real time?
Q4: What is the ideal exit for this strategy? Is it alwasy wait for (-1) signal to appear?
Q5: How often should I scan for signals or what timeframe is best for this strategy? Can I perform same analysis considering 4, 2, 1 Hour candles (Not sure how volatility would work in this scenario)? Will this strategy work for weekly expiry?
Q6: What happenes if I enter a position based on daily or EOD data (as in this example) and the underlying moves furiously in my opposite direction? What is the stoploss/evolve that can be done to prevent this position from going horribly wrong. What is the contingency planning if the position goes against us??
Q7: When should we look to enter such positions in terms of volatility ( low or high)? For ex. In the case of Calendar spread it is ideal to execute calendar spread with low volatility.
Q8: Now again coming back to our example: Since we get a (-1) signal on 2017-08-30, we exited previous position but according to this example, do ew again create a different position for the signal (-1) generated on 2017-08-30? Which means, we exit previous position on the early morning of 2017-08-31 and create a new position (exactly reverse in this case) which would be:
Buy near month @ 191.2 and
Sell far month @ 259.7
( please correct me if I am wrong here)
Q9: And now we wait for thee signal to be (+1) again to flip this position again and so on??? Is this the whole startegy mentioned here or am I missing anything important?
Q10: Is the brokerage and operating cost worth building such a strategy? In this example, we generated 1.35 points in 2-3 days. Considering just 1 lot of nifty, that would be equal to 67.5 Rs. So, daily time scale doesnt seem to be best for such a strategy ( again, correct me if I am wrong). Or should we consider taking these
Hey Amey
Q1. Yes, you are right up to this point.
Q2. Yes, you are right up to this point.
Q3. There are indeed multiple strikes that you can choose from. You can check this historically by looking out the various strikes. A good filter would be the strike having sufficient liquidity during the trading window. Once the strikes are selected, you can check the nature of the strike which gives the best results (how OTM, ITM the strike is for a new trade). In real time, you can treat the various strikes as individual stocks, and depending on the backtest, choose the OTM or the ITM strike for the trade, which until the trade is taken will update dynamically with the underlying spot.
Q4. The ideal exit is up to you. We have taken it as waiting for -1. You can filter the signal for minimum profit based on the backtest. You can implement a stop loss in a similar fashion. You can base an exit on the price of the underlying or a certain percentage move in the underlying. The ideal one for you will depend on your risk management and backtest results.
Q5. The concept is applicable to all the timeframes. The higher your frequency, the more the volatility. You can create an analysis of the volatility at various time frames and see which one you are most comfortable trading that gives you your edge.
Q6. Gap risk is always an issue in any overnight position. Strict risk-reward ratio and trading strikes with good liquidity is the best way in my opinion to handle such situations. Additionally, you can manipulate your backtest, to artificially create a gap risk and see how the strategy recovers from it. Some questions that you can answer would include, how comfortable you are with the drawdown; if you can manage the duration of the drawdown; will a repeat incident wipe your capital; etc.
Q7. A good scenario would be when you don't expect the forward volatility to change by a significant amount. You can either have a view on this, or use your backtest to figure out the fluctuation in forward volatility for profitable trades and loss-making trades to define a range of fluctuation for forward volatility.
Q8. You are right.
Q9. That's the whole strategy.
Q10. Incorporate all costs in your backtest. When you do that, minuscule profits will most likely turn to losses, which will give you a better view of the strategy. Even after such loss making trades, of the strategy is profitable in the long run, you should trade the signals as per the system.
Hope this helps.
Hi ,
I am still confused on this . Regarding signals , I n our Example the below was given
Trading Signal
Forward volatility greater than near-month volatility indicates that the far-month option is costlier when compared to the near-month option.
signal =-1 when forward volatility is more than near-month volatility.
Forward volatility less than near-month volatility indicates that the far-month option is cheaper when compared to the near-month option.
signal = 1 when forward volatility is lesser than near-month volatility.
for signal =-1 , Buy Near Month Option
for signal = 1 , Buy Far month options
Is my understanding correct . Can i set Straddle based on this .
Thank you !!!
With Warm Regards
Nandagopal
Hi Nandagopal,
There are two trades for each signal:
for signal = -1, Go short on the Far month option and long on the Near month option.
for signal = 1, Go short on the Near month option and long on the Far month option.
This is not exactly a Straddle as per standard definition as this trade is spread across two different expiries.
Hope this helps!
Thanks,
Akshay