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Monday, July 19, 2010

Results of Relative Volatility and P&F Trend Indicator Simulation

-I began two simulations few weeks ago using two of my indicators on TEMA chart. First, on June 29, I compared the value of the Estimated Future Volatility (EFV) indicator against the 30-day weighted implied volatility numbers for each stock that has options trading at penny increments. I picked out 10 stocks out of the top 40 whose implied volatility seemed low relative to the EFV indicator's value and 10 stocks out of the bottom 40 whose implied volatility seemed high relative to the EFV indicator's value. The logic behind this simulation was to see if the value of the EFV indicator could be used to systematically select stocks whose options prices were "overvalued" and thus should be sold or "undervalued" and thus should be bought-as part of a Volatility Arbitrage.
-Second, on June 30, I picked stocks whose P&F Trend Indicator changed from 1 to -1 or vice versa and bought the At-The-Money options, while at the same time selling an equal dollar amount of ATM options on an index (options on SPY in this instance). This is a variation of a strategy known as Dispersion, which typically consists of short selling options on a stock index while simultaneously buying options on the component stocks. Here, we are buying only options on stocks that shows a change in P&F Trend indicator. The P&F Trend indicator changes when a stock price moves a certain amount counter to the previous direction (often an established trend). The assumption is that regardless of whether the countertrend buying/selling power succeeds or fails to reversing the established trend, enough energy has been built up to move the stock one way or the other, relative to the overall market.
-Before I discuss the results of the two simulations, I would just like to say that any observations I draw would be based on just these two simulations and that more and better simulations would need to be conducted before I could come up with definitive "conclusions". Furthermore, I am limited in resources and time to design and test more complex and detailed simulations.
-Results from Relative Volatility Simulation: I was disappointed that the simulation did not result in profits. In the first portfolio, I bought and sold ATM straddle/strangle for a net credit of $34 and ended on July expiration date with a net debit of $943. In the second portfolio, I bought and sold ATM call and put spreads for a net credit of $78 and ended on July expiration date with net debit of $1006. Trying to reduce the overall exposure risk by buying/selling option spreads actually resulted in higher losses
-Results from P&F Trend Indicator Simulation: I was encouraged that the simulation of portfolio 1 resulted in profits from net debit of $150 to net credit of $2,386. However, when I bought and sold ATM call and put speads in portfolio 2, it went from net credit of $130 to net debit of $454. Once again, what appeared to be a less risky portfolio performed worse.
-Observations from both simulations: Based on my past experiences and other testing done on the P&F Trend Indicator, I am encouraged to find that this simulation also supported my view that there is potential for profitable trading strategies, in this case buying ATM options of stocks while selling ATM options of SPY (a variation of Dispersion Strategy), whenever the P&F Trend Indicator changes on any given stock. However, more testing would be required on the EFV indicator. First of all, the design of the simulation was not ideal for evaluating the EFV indicator. In volatility Arbitrage, delta is systematically maintained neutral, therefore actual realized intraday volatility and changes in implied volatility during the period of simulation would be the determining factors as to the profit potential of the EFV Indicator, rather than what the closing price of the underlying was at a given period after the start of the simulation. Second, the EFV indicator was optimized using SPY historical prices and therefore might not be very effective when translated to other stocks.

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