Traders typically create mean-reverting systems to capture gains in anticipation of prices moving from their current levels to their long-run average levels. This week, we discuss whether to choose futures or options when you implement a short-run mean-reverting system.
Risk vs reward
A mean-reverting system trades assets that are not trending or directional. That is, your analysis indicates that the underlying or its futures price is likely to move within an identifiable price range. In contrast, a trend-following system trades assets that are either trending up or down.
In a short-run mean-reverting system, you identify the support and resistance levels for the underlying or its futures price. The objective is to go long when the price is closer to the support level and go short when the price is closer to the resistance level. The argument is that prices are likely to move within this range. The trade is fraught with risk. It is possible that the current test of the resistance level could lead to a price breakout. Likewise, the current test of the support level can lead to a price breakdown. Given that the permitted lot size acts as a contract multiplier during the life of a derivative contract, an adverse price movement translates to a large loss for futures. This is because of symmetrical payoff of futures as opposed to asymmetric payoff of options.
Typically, mean-reverting systems have known to generate frequent small gains and gather large infrequent losses. To protect your trading account from large losses, it is optimal to use options for such trades. Note that short calls and short puts are not preferable because a large adverse movement in an underlying could lead to large losses (attributed to the negative delta and gamma) for short option positions.
In addition to the asymmetric payoff, there is another reason to use long options for such trades. Calls (puts) will typically be cheaper as they will have low implied volatility when an underlying is declining (rising). This is because implied volatility is a function of demand for a strike. Calls (puts) will have lower demand when the underlying is declining (rising) and is trading near its support level (resistance level). Note that an option is said to be trading cheap in relation to its implied volatility, not in terms of its absolute premium. You should not initiate the trade if the position is unlikely to be gainful assuming your price target is achieved at expiry; the position will more gains if the price target is reached sooner.
What not to do
Short calls and short puts are not preferable because a large adverse movement in an underlying could lead to large losses
Optional reading
You can create nondiscretionary mean-reverting systems where trading rules are automated to give you anticipated reversal alerts. You can also use screeners (filters) to pick such stocks. Such screeners can be based on stocks trading within, say, a channel or within the Bollinger bands. You can use oversold/overbought oscillators to initiate the trade. A nondiscretionary system can program all these rules to enable systematic trading.
(The author offers training programmes for individuals to manage their personal investments)