Trend-Following Trading Strategy Using Options: Does It Make Sense?

In the investing world, there are a variety of popular trading strategies that investors use to make money. One of the most popular is trend-following. This involves trying to identify when an asset is in an uptrend or downtrend and then buying or selling accordingly. While this approach can be profitable, it can also be risky. A strategy to mitigate the risk is to use options as trading vehicles instead of linear underlyings.

But does it make sense to overlay an options trading strategy on top of a trend-following one? Reference [1] argued,

A market trend is a perceived tendency of a financial market to move in a particular direction over time. The conventional Dow theory classifies the market trends as: a secular trend for long-term frames, a primary trend for medium-term frames, and a secondary trend for short-term frames. However, the definitions of classical market trends are not very helpful in options trading because in practice, options trading often takes place within a short-term frame. Even in a long or medium term of a bull (bear) market, there is a probability of losing all investment for buying call (put) options and a probability of earning big money from buying put (call) options. Options traders are often puzzled by these incongruences. Besides, the conventional market trends are identified by using technical indicators with historical data which often shows time lags. Since future security prices are not easy to predict, market trends are often only shown in hindsight.

We agree with the authors that using options to trade traditional trend-following strategies is not trivial. This is because options prices depend not only on the underlying price (delta) but also on volatility (vega) and time decay (theta).

The authors went on and proposed a new scheme for categorizing the market trend,

Instead of using the classical view of the market trends, this paper stands on the viewpoint of options trading and simplifies the market trends into three concepts: uptrend, downtrend, and neutral trend. A necessary condition is assumed that not losing money for trading ATM options requires that the change in the stock price (up or down) must be at least greater than the premiums of the ATM options (i.e., c or p). As an example, a long straddle strategy was employed to calculate the breakeven points, with the upper limit, 𝑆0 + c, and the lower limit, 𝑆0 − p. When the growth rate of the underlying asset price is greater (less) than the upper (lower) limit, it is an (a) upward (downward) trend; when the growth rate is between the upper and lower bounds, it is a neutral trend.

However, we don’t think that their method for classifying the trend is of any originality. It’s just the implied/realized volatility analysis presented in a different way with the market drift taken into account. In addition, it’s not obvious that one can develop a profitable trading strategy based on the proposed method.

Let us know what you think.

References

[1] MG. Wu, H Hsu and J Wang, Market Trends and Options Trading: Viewpoint, Probability and Implications, Journal of Applied Finance & Banking, Vol. 11, No. 5, 2021, 95-119