Profitability of Volatility Trading Using Simple Trading Rules

Alfred H.S. Wong, Eric Chan

Research output: Book chapter/Published conference paperConference paperpeer-review

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Abstract

Despite its popularity, option strategies have received relatively scant attention in the literature. This paper investigates the profitability of volatility trading in the over-the-counter (OTC) currency option market using simple moving average trading rules. Two types of options strategies are examined in this paper, namely 'straddles' and 'risk reversals'.This study employs daily implied volatility quotes for five major currency pairs contributed by the London market makers from October 1, 2001 to July 31, 2006. Allowing for volatility and exchange rate spread, the trading rules retained positive returns in the majority of the currency pairs. The buy straddle signals generate positive average returns for four of the five currency pairs. For these currency pairs, more than half of the trades resulted in winning outcomes. Further, the average return of the buy trade is statistically different from the average return of the sell trade. This is especially evident for the USD/JPY straddles. Conversely, risk reversal trades produced less compelling outcomes with lower winning trades and returns. Thus our result suggests that the moving average trading rules are useful in volatility trading. In addition the profits from the option strategies are large enough to offset the transaction costs, a result that violates the market efficiency theory.
Original languageEnglish
Title of host publication14th GFC
EditorsGordon Walker
Place of PublicationUSA
PublisherGFC
Pages1-38
Number of pages38
Publication statusPublished - 2007
EventAnnual Global Finance Conference - Melbourne, Australia, Australia
Duration: 01 Apr 200704 Apr 2007

Conference

ConferenceAnnual Global Finance Conference
CountryAustralia
Period01/04/0704/04/07

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