Extending Shannon's Demon

Mentioned in the Fortune's Formula book review, I want to express some ideas around applying Shannon's Demon for long gamma option trades. 

Shannon's Demon review

"

His experiment, known as Shannon’s Demon, showed how it was possible to profit even from markets that were characteristic of a random walk, as long as they were volatile.

The experiment is simple: Imagine a stock that is highly jittery and either doubled or halved in value every day. You then invest half of your portfolio in the stock, while the rest remains in cash. At noon each day you rebalance the portfolio back to a 50-50 even split. So, if you started with $1,000 and the stock got cut in half, the following day your portfolio would be $750 ($250 in the stock $500 in cash). After rebalancing, the portfolio would have $375 in stock and $375 in cash. As the chart below shows that after rebalancing only 72 times our $1,000 initial investment is now worth just under $100,000! That is not a bad chunk of change given that we didn’t have to do any stock forecasting to make this profit! In fact, had you bought and held this stock you would make zero profit.

"
GestaltU

So we would require a very volatile asset to simulate this. Simply using leverage would not be practical for many risk management purposes. I think taking long option trades may be a good first step.

Long Gamma Option Trades

Roger Lowenstein has said
"
Markets can remain irrational longer than you can remain solvent.
"

Well not if I do it with long options. But that still doesn't mean it'd be profitable.

The price for risk mitigation is theta. Therefore, the trader must still over come the cost of theta to work Shannon's Demon into a trade with decent EV (Expected Value).

Intraday Trading Options Instead of Underlying Products

I have grown to prefer intraday trading options instead of underlying stocks/futures because of the theoretically superior risk management; this allow us to circumvent need for Stop Loss Orders . While the math for options valuations remain somewhat complex, I believe options markets are close enough to “efficient” that a robust edge purely in direction (1 of many Option Greek uncertainties) would be good enough to make money. 

Trading Strategy

Long only ATM (At The Money)/OTM (Out of The Money) options, this gives the trades a limited downside while leaving the trader open for potentially much higher reward. Pretty simple right? Well there’s a bit more to it as risk management still depends on the core logic of the trade. Viability still depends on several risk-related areas. 

Risk Management- Theta

Off actual trading experience, I’ve noticed that theta does not kick in like clockwork as academic theory implies; in the short span within the trading hours option prices are very much dependent on supply/demand within the exchanges, i.e. Market Microstructure. So what does this mean for practical trading?

Trade logic of shorter average position would have a greater advantage. Don’t worry about it in the short run. On some days time value would go in your favor, and some days it wouldn’t. In the long run, the near-efficiency would equal to a pretty small negatively Statistically Expected Value (EV) of roughly the expected Theta * Average Position Time (hours) / 24.

Therefore, the directional edge must overcome Theta + other transaction costs. A theoretical edge that takes your attention is likely to have a much higher EV than the expected damage off Theta.  If not, move on and develop another trade.

Risk Management- Liquidity

If the options are relatively illiquid (such as the ASX200 Index Options), bid/offer spreads tend to be significantly wide, and if the underlying volatility remains relatively low, the inherent transaction cost could sky rocket and make the trade negative EV . Trade the Limit Order Books, blindly putting in Market Orders puts the trader in additional, undesirable risks. 

Risk Management- Time Value

Of course we want to buy the cheapest options possible and work the gamma. We can simply buy the ATM/OTM option(s) at the lowest points off the Volatility Smile.