2 Volarbitrage

Cointegration Pairs Trading Strategy On Derivatives
By Ngai Hang CHAN

Co-Authors: Dr. P.K. LEE and Ms. Lai Fun PUN
Department of Statistics
The Chinese University of Hong Kong
November 27, 2013
1
Research supported in part by grants from GRF-RGC-HKSAR.
Ngai Hang CHAN | CUHK | 2013-11
1 / 31
Table of Contents
Introduction
Cointegration Pairs Trading Strategy on Stocks
Cointegration Pairs Trading Strategy on Derivatives
Empirical Study with Foreign Exchange Options
Further Trading Strategies
Conclusion and Further Discussion
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Cointegration Pairs Trading Strategy On Derivatives | Introduction
Introduction
3 / 31
Arbitrage
Arbitrage: free lunch; earning extra profit without taking additional risk.
The no arbitrage assumption serves as the building block of modern
finance. It is the cornerstone of the celebrated Black-Scholes models for
option pricing.
Statistical Arbitrage: An attempt to profit from the pricing efficiencies
that are identified through the use of mathematical models. Statistical
arbitrage attempts to profit from the likelihood that prices will trend
together toward a historical norm. Unlike arbitrage, statistical arbitrage is
not risk-free.
4 / 31
Style Investing
Barberis and Shleifer (2003) discussed style investing.
Style: Assets with similar characteristics.
Switchers
Allocate funds at the level of a style.
The amount allocated in each style depends on the past performance of that
style relative to other styles.
Switchers cause co-movements for the stocks in the same style.
5 / 31
Arbitrage Opportunity in Short-run

Wilson and Marashdeh (2007) argued that co-movements between
stock prices imply market efficiency in long-run equilibrium.
Co-movements cause arbitrage opportunity in short-run.
Inefficiency in the short-run is eliminated by arbitrage activities.
Resulting efficiency in the long-run equilibrium.
It is reasonable to think that stock has co-integration property in the

long-run.
We may take advantage of such a property to find statistical arbitrage
opportunities in the short-run.
6 / 31
Introduction
Some financial instruments move more or less in sync with each other,
because they are driven by similar fundamental (e.g. economic) factors.
For example,
Stock prices of Coca Cola and Pepsi.
Currency Pairs AUD/USD vs NZD/USD .
However, they do not move EXACTLY the same because of their
individual technical factors, which can be assumed to be noises on top of
the common movement.
Statistical Approach: Cointegration
Assume that the underlying are stochastic processes sharing the same
stochastic drift.
Filter out the co-movement of pairs of market instruments by identifying
possible stationary series which is a linear combination of two
non-stationary series (e.g. prices of two stocks).
7 / 31
Cointegration
Definition
Two non-stationary time series {Xt } and {Yt } are cointegrated if some
linear combination aXt + bYt , with a and b being constants, is a
stationary series.
There are two popular approaches to establish the cointegration

relationship:
Engle-Granger methodology (1987)
Johansen methodology (1988)
8 / 31
Cointegration Pairs Trading Strategy On Derivatives | Cointegration Pairs Trading Strategy on Stocks
9 / 31
The notion of cointegration has been widely used in finance and

econometrics, in particular in constructing statistical arbitrage
strategy in the stock market.
Profitability has been reported using the cointegration strategy on
stocks trading, see Chan (2010).
10 / 31
Cointegration
Pairs
Example: (Chan,
2010)Trading Strategy on Stocks
Let Xt and Yt be two stock prices at time t. Assume that
a log Xt + b log Yt is stationary, i.e. log Xt and log Yt are cointegrated.
By Taylor expansion,
X X0
Yt Yt0
The
has tbeen twidely
usedYin
finance
and)
a log
Xtnotion
+ b logofYcointegration
) + b(log
t a(log Xt0 +
t0 +
Xt0
Yt0
econometrics, in particular in constructing
statistical arbitrage
a
b
strategy in the stock
= market.
Xt +
Yt + a(log Xt0 1) + b(log Yt0 1).
Xt0
Yt0
Profitability
been reported using the cointegration strategy on
Because
a(log Xthas
0 1) + b(log Yt0 1) is a constant, the stationarity of
see Chan
(2010).
b
a
a logstocks
Xt + btrading,
log Yt implies
that
Xt Xt + Yt Yt is approximately stationary,
i.e.
a
Xt0 Xt
b
Yt0 Yt
should exhibit mean-reverting property.
We can initiate a position with c Xat shares of X and c Ybt shares of Y for
0
0
any given value c, where c can be considered as the starting initial capital.
10 / 31
Implementation of Trading Strategy on Stocks
11 / 31
Investigate possible cointegrated series from pairs of log(stock prices)

[or log(exchange rates)] based on the Johansen test (typically 5% of
pairs).
For each cointegration pairs, check if the current level of the
stationary series (i.e. a log Xt + b log Yt )) is too low/high against its
historical mean (e.g. Z -score = 2, +2).
Enter the trade (i.e. buy/sell Xat of X and Ybt shares of Y at time t0
and expect the stationary series a log Xt + b log Yt ) to mean-revert
back to it historical average level.
For a portfolio with 46 stocks, there are C246 = 575 possible
combination of stock pairs and E(Number of cointegrated series at
t0 ) 575x5% 29 pairs.
Works well for stock prices in the same sector, harder to interpret for
stocks from different sectors.
Not much juice on simple financial instruments, as other statistical
techniques based on mean-reversion assumption (e.g. PCA) is able to
detect similar trades.
11 / 31
Cointegration Pairs Trading Strategy On Derivatives | Cointegration Pairs Trading Strategy on Derivatives
Would like to extend the cointegration strategy on derivatives. For

example, extend from Currency pairs of AUD/USD vs NZD/USD to
Option on AUD/USD vs option on NZD/USD.
12 / 31
Cointegration Pairs Trading Strategy on Derivatives
12 / 31
Implied volatility is the assessment of the future variation in an underlying

asset.
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asset.
Even though
not cointegrated
SX
X2
cointegrated
SY
Y2
13 / 31

asset.
Even though
not cointegrated
SX
X2
cointegrated
SY
Y2
because they may be affected by the same exogenous event so that people
have the same perspective to the variations of the underlying assets.
Similar with the cointegration pairs trading strategy on stocks , a divergence from the mean level of the cointegration pairs can be captured to
make a profit.
13 / 31
How to trade volatility?
14 / 31
How to trade volatility?
Straddle!!
14 / 31
Why Straddle?
15 / 31
What is Straddle?
Definition: A long (short) straddle is long (short) a call option and a put
option at the same strike price and expiration date.
15 / 31
What is Straddle?
Definition: A long (short) straddle is long (short) a call option and a put
option at the same strike price and expiration date.
At-the-money Straddle (STt )

STt = Ct + Pt =
2
St
T t + O(St 2 (T t))
15 / 31
How the cointegration strategy works?

Suppose the trading signal is
TSt = atX btY I (0), where a, b > 0,
the z-score of the trading signal is
Zt =
TSt
,
where are are the mean and the standard deviation of the trading
signal.
16 / 31
How the cointegration strategy works?

Suppose the trading signal is
TSt = atX btY I (0), where a, b > 0,
the z-score of the trading signal is
Zt =
TSt
,
where are are the mean and the standard deviation of the trading
signal.
TSt << tX too low comparing to tY , long STtX and short STtY .
TSt >> tX too high comparing to tY , long STtY and short STtX .
16 / 31
How does the cointegration strategy work?

Setting up the Trading Portfolio
For t (t0 , T ),the value of the straddles portfolio t becomes
t = A (CSXt + PSXt ) B (CSYt + PSYt ),
0
where CSXt , PSXt , CSYt , PSYt at time t0 are at-the-money options.

0
Based on the Taylor expansion, 4t can be approximated by

4t =
t
1 2 t
t
t
X
Y
4
S
+
4
S
+
(4StX )2
4t +
t
t
t
2 (StX )2
StX
StY
1 2 t
t
t
+
(4StY )2 +
4 tX +
4 tY ,
Y
X
2
2 (St )
t
tY
17 / 31

Setting up the Trading Portfolio
For t (t0 , T ),the value of
the straddles
portfolio t becomes
t
t
X
Vega Part : I =
4
+
4 tY
t
X
Y
X
X
t = A (CSt t+ PSt ) B t (CSYt + PSYt ),

0
0
0
0
t
t
X
Y
Delta Part : II =
4 St +
4 St
X
Y
where CSXt , PSXt , CSYt , PSYt at
t0 are S
at-the-money
options.
Stime
t
t
0
0
0
0
1 2 t
1 2 t
X 2
(4S
)
+
(4StY )2
Gamma Part : III =
t
2 (StX )2
2 (StY )2
Based on the Taylor expansion,
4
t t can be approximated by
Theta Part : IV =
4t
t
1 2 t
t
t
t
X
Y
4
S
+
4
S
+
(4StX )2
4t =
4t +
t
t
X
Y
X )2
t
2
S
S
(S
t I + II + III
t + IV .
t
i.e. 4t =
1 2 t
t
t
+
(4StY )2 +
4 tX +
4 tY ,
Y
X
2
2 (St )
t
tY
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Requirements of the trade

The trade will be dominated by vega if the trade fulfills the following
requirements:
1
Short-term period of trading;
Using long-dated option;
The mean of the trading signal is negative (positive), the

position is initiated when the trading signal is too low (high).
Otherwise, the position should not be initiated.
In the derivation below,(it is shown that at time t,
t
2TS
, long the portfolio,
t
T
t
= t
TS
t ,
short the portfolio.
2 T t
where TSt = Zt + , and are the mean and standard deviation of the
trading signal TSt .
18 / 31

Because the trading is in a short-term period since time t0 , the Greek
Letters can be approximated. Assume that (TS) < 0 and the portfolio of
longing STtX and shorting STTY is entered.
p
p
Let A = 2 SaX , B = 2 SbY , where a, b are the coefficients of the
cointegration.
t0
t0
By the approximation of (d1 ) and (d2 ):

(d1 ) =
(d2 ) =
1
2
1
2
T t
2
T t
2
+ O(d12 ),
+ O(d22 ),
and the assumption that St is driven by the Geometric Brownian motion

dSt
St
= r dt + r dWt ,
where r is the realized volatility, I, II, III, IV can be approximated as

follows.
19 / 31

Because the trading is in a short-term period since time t0 , the Greek
Letters canApproximation
be approximated. Assume that (TS) < 0 and the portfolio of
longing STtX and shorting
p STTY is entered.
E(I ) p T t0 (E(TSt ) TSt0 ),
p
b
b are the coefficients of the
Let A = 2 SaX , B = t
2 StY ,Twhere
t0 rta,
t0
0 TSt0
0
E(II
)
,
cointegration.
2
aE( r )2 bE(Yr )2
t
1 ) and((d2X):X
E(III ) of
(d
),
By the approximation
tY0
2 T t0 t0
(d )t
= 1 TS
+ t0T2t + O(d12 ),
E(IV ) 1 2
,
(d )2 =T1
t0T t + O(d 2 ),
2
where t =that
t S
t0 , isrt0driven
is the by
risk-free
rate, (Xr Brownian
)2 and motion
and the assumption
the Geometric
t
(Yr )2 are the average
volatilities.
dSt squared annual
= r dt + r dW realized
,
St
where r is the realized volatility, I, II, III, IV can be approximated as

follows.
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Vega Part: I = T t0 (E(TSt ) TSt0 )

This is the main profit to be captured by the trading strategy. Should the
trading signal reverts back to its mean value, then E(I ) > 0.
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Proposition 1
If the trade is in a short-time period, E(II ) + E(IV ) > 0.
Proposition
Vega Part:
I = T 2t0 (E(TSt ) TSt0 )
Assume
This is the
main that
profit to be captured by the trading strategy. Should the
trading signal
reverts
back
to its mean
value,implied
then E(I
) > 0. and
1 Annualized
volatilities
(include
volatility
realized volatility) of the underlying assets are
smaller than 80% ;
2
1 i
c t0
(TSt ) > 1.
< ir < cti 0 , for i = X and Y , c > 1;
Then E(I ) + E(III ) > 0.
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In conclusion
If the implied volatilities of the underlying assets are not too high and do
not deviate too far from the corresponding realized volatilities, and if
E(TSt ) TSt0 is large enough, then
E(t ) = E(I ) + E(II ) + E(III ) + E(IV ) > 0.
21 / 31
Cointegration Pairs Trading Strategy On Derivatives | Empirical Study with Foreign Exchange Options
22 / 31
23 / 31
Find out the cointegration pairs

In our analysis, FX options with 3-month expiry of 30 currency pairs (e.g.
EUR/USD) for all the strikes from 2009Q4 to 2011Q4 were considered.
The Johansen test is based on the data from 2009Q4-2011Q3. The cointegration pairs identified will be used as the trading signals for 2011Q4.
24 / 31
Find out the cointegration pairs

In our analysis, FX options with 3-month expiry of 30 currency pairs (e.g.
EUR/USD) for all the strikes from 2009Q4 to 2011Q4 were considered.
The Johansen test is based on the data from 2009Q4-2011Q3. The cointegration pairs identified will be used as the trading signals for 2011Q4.
According to the results from Johansen test, the implied volatilities of

GBPNZD and GBPUSD are significantly cointegrated with the parameters
a = 0.6762 and b = 1.0000, i.e. the trading signal is
TS = 0.6762 GBPNZD GBPUSD .
24 / 31
Details of cointegration pairs
zsscoreofftheTraadingSignal
3
2
1
0
1
2
3
10/1/2009
4/1/2010
10/1/2010
4/1/201
11
10/1/2011
The z-score of the Trading Signal on Oct 3rd , 2011 is 3.39 and on Oct 7th ,
2011, it is 1.52.
25 / 31
Details of the trade

CumulativeP/L
800
700
600
500
400
300
200
100
0
(100)
4Oct
ActualP/L
5Oct
vega
delta
6Oct
gamma
7Oct
theta
HighOrder
Figure: Change of P/L due to Greek Letters
The value of the portfolio is -USD3,465 on 03/10/2011, and then the value increases to -USD2,783 on 07/10/2011. Finally, we gain +USD682 by
this strategy.
26 / 31
More examples
We identify possible cointegration in any two currency pairs, based on the
data from 2009Q1-2010Q4. The cointegration pairs identified will be used
as trading signals for 2011Q1. We repeated the same procedure to identify
possible cointegration pairs during 2009Q2-2011Q1, 2009Q3-2011Q2 and
2009Q4-2011Q3, which would be served as the trading signals for 2011Q2,
2011Q3 and 2011Q4.
27 / 31
More examples
We identify possible cointegration in any two currency pairs, based on the
data from 2009Q1-2010Q4. The cointegration pairs identified will be used
as trading signals for 2011Q1. We repeated the same procedure to identify
possible cointegration pairs during 2009Q2-2011Q1, 2009Q3-2011Q2 and
2009Q4-2011Q3, which would be served as the trading signals for 2011Q2,
2011Q3 and 2011Q4.
27 / 31
More Examples
The profit by this strategy in each trade is as follow.
3,000
Q1
Q2
Q3
Q4
2,000
1,000
(1,000)
(2,000)
1,976
(3,000)
1,290
8,691
3,998
Total Profit: -1,427USD

28 / 31
Cointegration Pairs Trading Strategy On Derivatives | Further Trading Strategies
Further Trading Strategies
29 / 31
StrategyPerformance:StraddlesonHKStocks
CorePartofthetrade
MeanReversionof
TradingSignal
=>positiveVega
PositiveTheta(Carry)
Tradeswithpositive
theta(P/Lovertime)
werechosenfromour
tradeselectioncriteria
NegativeGamma Distribution 0 for

OppositetoTheta
ofDelta
each
ingeneral,a
roughly
trade
functionof
symmetric
realizedvolatilities 0 onaverage
30 / 31
StrategyPerformance:StraddlesonFXRates
WhydoesntworkonFXRates?
Moreaffectedbyfundamentalfactors(vs.technicalfactorsforstocks)
WhathappenedinJuly August2011?
RiskAversion =>Realizedvol =>Impliedvol =>Cointegration Opportunities
NeedacriteriononImpliedvol basedonforecastsofRealizedvol
31 / 31
Cointegration Pairs Trading Strategy On Derivatives | Modeling and Forecasting Realized Volatilities
Modeling and Forecasting Realized Volatilities
32 / 31
Estimation of Realized Volatility

1. Historical Estimate: Log-daily-return rt = log(Xt ) log(Xt1 ),
t2 =
R
H
X
(rti+1 r t )2 /(H 1),
with r t =
H
X
rti+1 /H
i=1
i=1
2. J.P. Morgan Risk Metrics: Exponentially Weighted Moving Average of

squared log-daily-return:
v
u
H
u 1 X
2
t
Rt =
i (rti+1 r t )2 , where = 0.94.
1 H
i=1
3. Garman-Klass Estimates: Assume the underlying Xt follows the

Geometric Brownian Motion: dXt = Xt dt + Xt dWt ,
2
2
t2 = 0.17(Ot Ct1 ) + 0.83(ut dt ) ,
R
f
(1 f )4 log 2
where Ot , Ct , ut and dt are the Open, Close, High and Low of the underlying
of the t-th day, and f is fraction of non-trading hours in a trading day.
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4. High Frequency Estimate: Let {rn,t }, n = 1, . . . , N, t = 1, . . . , T be

the log-return of an underlying asset at the nth minute of the t-th day.
Assume that rn,t are i.i.d with mean zero and constant variance 2 /N.
The High Frequency Estimate is
t2 =
R
N
X
2
rn,t
for t = 1, . . . , T .
n=1
Advantages of High Frequency Estimate:

a) The estimate depends on todays information ONLY No lagging issue
as in Historical Estimate and JP Morgan Risk Metrics.
b) Unbiased estimator for 2 . In contrast, Garman-Klass underestimates
2 , as the high and low observed in discrete time under- and
over-estimate the high and low in GBM
34 / 31
Forecasting Realized Volatilities Rt Andersen, Bollerslev, Diebold and

Labys (2003) proposed the use of ARFIMA(1,1,0) model on the log of
realized volatilities of high-frequency estimates
t )
yt = log(R
(L)(1 L)d yt = t ,
i.i.d.
t N(0, 2 ).
The model is able to

a) capture the asymmetric property of the unconditional distribution of
t ;
the unconditional distribution of R
t ;
b) capture the long-memory property of R
c) provide the best 1- and 10-day ahead realized volatilities forecasts
among 10+ models.
35 / 31

r
Gamma Part: E(III ) =
aE( )
t
( XX
2 T t0
t0
bE(Yr )2
),
tY0
where Xr and Yr are
the average squared future annual realized volatilities for longing the
portfolio.
36 / 31

r
Gamma Part: E(III ) =
aE( )
t
( XX
2 T t0
t0
bE(Yr )2
),
tY0
where Xr and Yr are
the average squared future annual realized volatilities for longing the
portfolio.
Andersen, Bollerslev, Diebold and Labys (2003) introduced the following
methods to model and forecast the realized volatility.
Modelling: High-Frequency Realized Volatility Estimation,
P
2
st2 = N
n=1 rn,t , for t = 1, 2, , T ,
Forecasting: ARFIMA model:
(L)(1 L)d (yt ) = t ,
where yt = log st , d is the order of integration and t is a vector white
noise process.
36 / 31
Additional Criterion
Implied-Realized Criterion
aE(Xr )2 bE(Yr )2
K=
/
tX0
tY0
d, if TS < 0,
u, if TS > 0,
Here, d set as 0.7 and u set as 1.3.
37 / 31
Additional Criterion
Implied-Realized Criterion
aE(Xr )2 bE(Yr )2
K=
/
tX0
tY0
d, if TS < 0,
u, if TS > 0,
Here, d set as 0.7 and u set as 1.3.
Gamma-Vega Criterion
Vega
| T t0 (E(TSt ) TSt0 )|
l,
K =|
|=
aE(Xr )2
bE(Yr )2
Gamma
| 24t
(
)|
X
Y
T t
0
t0
t0
Here, l set as 11.

37 / 31
PerformanceoftheOriginalStrategy
PeriodwithHighRealizedVolatilities(July August2011)
38 / 31
PerformanceofTradingStrategy2
MostofthetradesinJulyAugustwerefilteredout
39 / 31
PerformanceofTradingStrategy3
40 / 31
SummaryofTradingStrategies
41 / 31
Cointegration Pairs Trading Strategy On Derivatives | Conclusion and Further Discussion
Conclusion and Further Discussion
42 / 31
Conclusion
Cointegration strategy has been applied into the

derivatives.
If the trading signal can show mean-reverting in a
short-term and the realized volatility is not too high
and deviates too far from the implied volatility, the
portfolio makes profit.
The additional criteria, Implied-Realized Criterion and
Gamma-Vega Criterion, are effective.
43 / 31
Further Discussion
The number of traded underlying assets can be more
than two.
The dynamic hedging can be imposed in the strategy
to minimize the impact of delta. This method may
weaken the short-term period trading restriction,
but costly.
The method for modeling and forecasting realized
volatility can be revised and the notion of fractional
cointegration may be pursued for the further study.
44 / 31
Thank You
45 / 31
Cointegration Pairs Trading Strategy On Derivatives | Appendix
Engle-Grangers Methodology
Consider a p-dimensional non-stationary I (1) time series {xt }. xt can be

partitioned into (x1t , x02t )0 , where x1t is a scaler and x2t is an (p 1) 1
vector.
Through the ordinary least squares (OLS) method, we have

0 + ut .
x1t = x
2t
0 I (0), it means that there exist
= (1, 0 )0 such that
If ut = x1t x
2t
t I (0), i.e. xt is cointegration.
x
46 / 31
Johansens Methodology
Consider a p-dimensional non-stationary I (1) time series {Xt }, which
follows a VAR(k) process:
Xt = 1 Xt1 + 2 Xt2 + + k Xtk + t , t = . . . , 1, 0, 1, . . . ,
where 1 , 2 , . . . , k are p p matrices, and t is Gaussian random
vector with mean 0 and covariance matrix .
Note that the above equation can be rewritten as a Vector Error
Correction Model (VECM):
Xt = Xt1 + 1 Xt1 + + k1 Xtk+1 + t ,
P
P
where = ki=1 i I , l = kj=l+1 j , l = 1, . . . , k 1. Hence, l ,
l = 1, . . . , k 1 are unrestricted.
47 / 31
Johansens Methodology
0
If = pr pr
, where r < p, then 0 Xt is stationary, where is the
adjustment coefficients and is the cointegration vector.
Trace test:
Ltrace = N
Pp
i ),
H 0 : Kc = r
vs
H1 : Kc = p.
i=r +1 log(1
Maximum eigenvalue test:

r +1 ),
Leig = N log(1
H0 : Kc = r
vs
H1 : Kc = r + 1.
Here N is the sample size, i is the i-th largest canonical correlation and
Kc is the number of cointegrating vector.
48 / 31
Appendix A
First of all,
Ct = St e q(T t) (d1 ) Ke r (T t) (d2 ),

Pt = Ke r (T t) (d2 ) St e q(T t) (d1 ),
2
where d1 =
log( SKt )+(r q+ 2 )(T t)
,
T t
d2 = d1 T t.
By the Taylor expansion,

(d1 ) = (0) + (0)d1 + 0 (0)d12 + O(d12 ) =
(d2 ) = (0) + (0)d2 + 0 (0)d22 + O(d22 ) =
Then,
1
2
1
2
+
+
d1
2
d2
2
+ O(d12 ),
+ O(d22 ),
St e q(T t)
T t + O(St 2 (T t)),
2
St e q(T t)
Pt =
T t + O(St 2 (T t)).
2
q
STt = Ct + Pt = 2 St T t + O(St 2 (T t))

Ct =
Hence,
49 / 31
Appendix B
Proposition
If the trade is in a short-time period, E(II ) + E(IV ) > 0.
Proof.
In section 3.3.1, we know that theta (IV) is a positive net carry in the
trade. Compared the expected value of theta (IV) with that of delta (II),
E(IV )
1

E(II ) = (T t0 )rt .
0
Because T t0 is smaller than one (year) and rt0 is very small (0%-5%
in most countries), |E(II )| << |E(IV )|. Hence,
E(II ) + E(IV ) |E(IV )| |E(II )| > 0,
i.e. the loss due to delta is likely to be compensated by the positive carry
from IV.
50 / 31
Appendix C
Proposition
Assume that
1
Annualized volatilities (include implied volatility and realized

volatility) of the underlying assets are smaller than 80% ;
1 i
c t0
(TSt ) > 1.
< ir < cti 0 , for i = x, y , c > 1;
Then E(I ) + E(III ) > 0.
Proof
Under assumptions (1) and (2), one can show that
(
|E(III )| = | 2t
T t
0
aE(Xr )2
tX0
bE(Yr )2
)|
tY0
2
0.4c
4t .
T t0
51 / 31
cont.
Recall that the trade requires using long dated options and to trade in a
short-term period. To strike a balance between the trading requirements
and options liquidity, the maturity of the options should be at least three
months and the trade should not last over one month. i.e.
T t0
t
3.
Vega is the main profit in the trade. Compared the expected value of
gamma with that of vega,
E(I ) T t0 (E(TSt )TSt ) 7.5
0

2 (E(TSt ) TSt ).

0
aE( r )2
bE( r )2
E(III ) =
c
t
T t0
X
tX
0
Y
tY
0
52 / 31
cont.
The trade is initiated when TSt0 is too negative comparing to the mean
level (E(TSt )), and c is close to 1. Hence,
7.5
(E(TSt )
c2
TSt0 ) >
15
(TSt )
c2
>> 1,
and therefore
E(I ) + E(III ) |E(I )| |E(III )| > 0.
53 / 31

2 Volarbitrage

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Cointegration Pairs Trading Strategy On Derivatives

Cointegration Pairs Trading Strategy On Derivatives

By Ngai Hang CHAN

Research supported in part by grants from GRF-RGC-HKSAR.

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy On Derivatives

Cointegration Pairs Trading Strategy on Stocks

Cointegration Pairs Trading Strategy on Derivatives

Empirical Study with Foreign Exchange Options

Further Trading Strategies

Conclusion and Further Discussion

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy On Derivatives | Introduction

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy On Derivatives | Introduction

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy On Derivatives | Introduction

Switchers cause co-movements for the stocks in the same style.

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy On Derivatives | Introduction

Arbitrage Opportunity in Short-run

It is reasonable to think that stock has co-integration property in the

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy On Derivatives | Introduction

Cointegration Pairs Trading Strategy On Derivatives | Introduction

There are two popular approaches to establish the cointegration

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy on Stocks

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy on Stocks

The notion of cointegration has been widely used in finance and

Ngai Hang CHAN | CUHK | 2013-11

should exhibit mean-reverting property.

Implementation of Trading Strategy on Stocks

Ngai Hang CHAN | CUHK | 2013-11

Investigate possible cointegrated series from pairs of log(stock prices)

Would like to extend the cointegration strategy on derivatives. For

Ngai Hang CHAN | CUHK | 2013-11

Cointegration Pairs Trading Strategy on Derivatives

Ngai Hang CHAN | CUHK | 2013-11

Implied volatility is the assessment of the future variation in an underlying

Ngai Hang CHAN | CUHK | 2013-11

Implied volatility is the assessment of the future variation in an underlying

Ngai Hang CHAN | CUHK | 2013-11

Implied volatility is the assessment of the future variation in an underlying

Ngai Hang CHAN | CUHK | 2013-11

How to trade volatility?

Ngai Hang CHAN | CUHK | 2013-11

How to trade volatility?

Ngai Hang CHAN | CUHK | 2013-11

Ngai Hang CHAN | CUHK | 2013-11

Ngai Hang CHAN | CUHK | 2013-11

At-the-money Straddle (STt )

Ngai Hang CHAN | CUHK | 2013-11

How the cointegration strategy works?

Ngai Hang CHAN | CUHK | 2013-11

How the cointegration strategy works?

How does the cointegration strategy work?

where CSXt , PSXt , CSYt , PSYt at time t0 are at-the-money options.

Based on the Taylor expansion, 4t can be approximated by

Ngai Hang CHAN | CUHK | 2013-11

How does the cointegration strategy work?

t = A (CSt t+ PSt ) B t (CSYt + PSYt ),