Free lunches

Liquid financial instruments are normally correctly valued.  There are some situations when this does not apply; these are called anomalies e.g. momentum, post-earnings-announcement-drift etc.  To beat the broad market returns consistently, a strategy must be based around this type of situation.  These anomalies are grounded in a structural market behavior which prevents the inefficiency from being arbitraged.

Here are two examples of commonly discussed strategies not based on a reliable behavior:

1) Indicator readings e.g Buy RSI < 30, Sell RSI > 70

These are very appealing to the beginner backtester due to the ease of coding and likelihood that a combination of optimized parameters (out of millions) will generally look good over a specific test period.

If the market rewarded one indicator value over another, sophisticated players would soon take advantage and thereby cause it to disappear.

2) Options strategies e.g. iron condor

There are many on-line services purporting to sell profitable strategies combining various options types.  The problem is that each option is accurately priced based on current volatility and underlying price.  An iron condor profits when underlying price stays in a range.  This allows the sold options to expire worthless.  Are buyers generously donating free money?  Alas no, the trade gives a 90% chance of profit with a 10% reward to risk ratio (i.e. zero expectancy!).

How about the mythical ‘adjustments’ which reposition legs during extreme market moves.  If the overall strategy is profitable then the adjustments are solely responsible and should be traded alone (thus saving commissions).  Inefficiencies are more likely to be found during extreme moves than regular times. [If readers have more data on this, please let me know].

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11 thoughts on “Free lunches

  1. Pingback: Daily Wrap for 5/14/2013 | The Whole Street

  2. Would you say the XIV roll yield strategy is a strategy based in structural market behavior? Thanks and keep up the great work.

  3. You seem to think that momentum is a “legit” anomaly while mean reversion is not. Why?

    As for option implied volatility, it is one of the most enduring “anomalies” around. Hedgers (i.e. buyers) pay a significant premium in terms of the difference between implied and realized volatility.

    • I have no research literature on a reversion anomaly but would like to obtain some if you have links?

      Does the sum of premiums exceed the tail losses? I have tested many options strategies without finding a robust income producer (today I start with a known anomaly to save time!). Selling naked puts may be profitable but can blow up any time: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=375784

  4. Thanks Qusma, I agree it definitely is one of the bigger anomalies out there, but I was referring more to the roll yield in the VIX ETN products due to contango or at times backwardation.

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