151 Trading Strategies

A trading strategy can be defined as a set of instructions to achieve certain asset holdings by some predefined times t1, t2, . . . , which holdings can (but need not) be null at one or more of these times. In many cases, the main objective of a trading strategy is to make a profit, i.e., to generate a positive return on its investment. However, some viable trading strategies are not always outright profitable as stand-alone strategies. E.g., a hedging strategy can be a part of a bigger plan, which itself can but need not be a trading strategy. Thus, an airline hedging against rising fuel costs with commodity futures is a trading strategy, which is a risk management step in executing the airline’s business strategy of generating profits through its services.

 

In the case of trading strategies that are intended to be outright profitable as stand-alone strategies, one may argue that the phrase “buy low, sell high” captures their essence. However, this viewpoint is somewhat superfluous and, while it applies to trading strategies that buy and sell a single asset (e.g., a single stock), it would exclude a whole host of viable strategies that do not work quite like that. E.g., a trading strategy that uses a hedging sub-strategy for risk management may not always “buy low, sell high” when it comes to a particular asset in its portfolio. This is because hedging risk—or, essentially, transferring some risk to other market participants—is not free, and often a trader will pay a premium for hedging some risks in a trading strategy to achieve its objectives. Another example would be the so-called statistical arbitrage, wherein the trading portfolio can consist of, e.g., thousands of stocks and profitability is typically not achieved by buying low and selling high each stock or even any discernable groups of stocks, but statistically, across all stocks, with some trades making money and some losing it. It gets complicated quickly.

Introduction and Summary

References 

2 Options 5

2.1 Generalities 5

2.2 Strategy: Covered Call 7

2.3 Strategy: Covered Put 7

2.4 Strategy: Protective Put 8

2.5 Strategy: Protective Call 8

2.6 Strategy: Bull Call Spread 8

2.7 Strategy: Bull Put Spread 9

2.8 Strategy: Bear Call Spread 9

2.9 Strategy: Bear Put Spread 10

2.10 Strategy: Long Synthetic Forward 10

2.11 Strategy: Short Synthetic Forward 10

2.12 Strategy: Long Combo 11

2.13 Strategy: Short Combo 11

2.14 Strategy: Bull Call Ladder 12

2.15 Strategy: Bull Put Ladder 12

2.16 Strategy: Bear Call Ladder 13

2.17 Strategy: Bear Put Ladder 13

2.18 Strategy: Calendar Call Spread 14

2.19 Strategy: Calendar Put Spread 14

2.20 Strategy: Diagonal Call Spread 15

2.21 Strategy: Diagonal Put Spread 16

2.22 Strategy: Long Straddle 16

2.23 Strategy: Long Strangle 17

2.24 Strategy: Long Guts 17

2.25 Strategy: Short Straddle 18

2.26 Strategy: Short Strangle 18

2.27 Strategy: Short Guts 18

2.28 Strategy: Long Call Synthetic Straddle 19

2.29 Strategy: Long Put Synthetic Straddle 19

2.30 Strategy: Short Call Synthetic Straddle 20

2.31 Strategy: Short Put Synthetic Straddle 20

2.32 Strategy: Covered Short Straddle 20

2.33 Strategy: Covered Short Strangle 21

2.34 Strategy: Strap 21

2.35 Strategy: Strip 22

2.36 Strategy: Call Ratio Backspread 22

2.37 Strategy: Put Ratio Backspread 22

2.38 Strategy: Ratio Call Spread 23

2.39 Strategy: Ratio Put Spread 23

2.40 Strategy: Long Call Butterfly 24

Strategy: Modified Call Butterfly 24

2.41 Strategy: Long Put Butterfly 25

Strategy: Modified Put Butterfly 25

2.42 Strategy: Short Call Butterfly 25

2.43 Strategy: Short Put Butterfly 26

2.44 Strategy: “Long” Iron Butterfly 26

2.45 Strategy: “Short” Iron Butterfly 27

2.46 Strategy: Long Call Condor 27

2.47 Strategy: Long Put Condor 28

2.48 Strategy: Short Call Condor 28

2.49 Strategy: Short Put Condor 28

2.50 Strategy: Long Iron Condor 29

2.51 Strategy: Short Iron Condor 29

2.52 Strategy: Long Box 30

2.53 Strategy: Collar 30

2.54 Strategy: Bullish Short Seagull Spread 31

2.55 Strategy: Bearish Long Seagull Spread 31

2.56 Strategy: Bearish Short Seagull Spread 32

2.57 Strategy: Bullish Long Seagull Spread 32

References 33

3 Stocks 41

3.1 Strategy: Price-Momentum 41

3.2 Strategy: Earnings-Momentum 43

3.3 Strategy: Value 44

3.4 Strategy: Low-Volatility Anomaly 44

3.5 Strategy: Implied Volatility 45

3.6 Strategy: Multifactor Portfolio 45

3.7 Strategy: Residual Momentum 46

3.8 Strategy: Pairs Trading 48

3.9 Strategy: Mean-Reversion—Single Cluster 49

Strategy: Mean-Reversion—Multiple Clusters 50

3.10 Mean-Reversion—Weighted Regression 52

3.11 Strategy: Single Moving Average 53

3.12 Strategy: Two Moving Averages 54

3.13 Strategy: Three Moving Averages 54

3.14 Strategy: Support and Resistance 55

3.15 Strategy: Channel 55

3.16 Strategy: Event-Driven—M&A 56

3.17 Strategy: Machine Learning—Single-Stock KNN 57

3.18 Strategy: Statistical Arbitrage—Optimization 59

Dollar-Neutrality 61

3.19 Strategy: Market-Making 63

3.20 Strategy: Alpha Combos 64

3.21 A Few Comments 66

References 67

4 Exchange-Traded Funds (ETFs) 87

4.1 Strategy: Sector Momentum Rotation 87

Strategy: Sector Momentum Rotation with MA filter 88

Strategy: Dual-Momentum Sector Rotation 88

4.2 Strategy: Alpha Rotation 89

4.3 Strategy: R-squared 89

4.4 Strategy: Mean-reversion 90

4.5 Strategy: Leveraged ETFs (LETFs) 91

4.6 Strategy: Multi-asset Trend Following 91

References 92

5 Fixed Income 99

5.1 Generalities 99

Zero-Coupon Bonds 99

Bonds with Coupons 99

Floating Rate Bonds 100

Swaps 101

Duration and Convexity 102

5.2 Strategy: Bullets 103

5.3 Strategy: Barbells 103

5.4 Strategy: Ladders 104

5.5 Strategy: Bond Immunization 105

5.6 Strategy: Dollar-Duration-Neutral Butterfly 106

5.7 Strategy: Fifty-Fifty Butterfly 107

5.8 Strategy: Regression-Weighted Butterfly 107

Strategy: Maturity-Weighted Butterfly 108

5.9 Strategy: Low-Risk Factor 108

5.10 Strategy: Value Factor 108

5.11 Strategy: Carry Factor 109

5.12 Strategy: Rolling Down the Yield Curve 110

5.13 Strategy: Yield Curve Spread (Flatteners and Steepeners) 110

5.14 Strategy: CDS Basis Arbitrage 111

5.15 Strategy: Swap-Spread Arbitrage 111

References 112

6 Indexes 121

6.1 Generalities 121

6.2 Strategy: Cash-and-carry Arbitrage 121

6.3 Strategy: Dispersion Trading in Equity Indexes 122

Strategy: Dispersion Trading: Subset Portfolio 123

6.4 Strategy: Intraday Arbitrage Between Index ETFs 125

6.5 Strategy: Index Volatility Targeting with Risk-Free Asset 125

References 126

7 Volatility 131

7.1 Generalities 131

7.2 Strategy: VIX Futures Basis Trading 131

7.3 Strategy: Volatility Carry with Two ETNs 133

Strategy: Hedging Short VXX with VIX Futures 133

7.4 Strategy: Volatility Risk Premium 134

Strategy: Volatility Risk Premium with Gamma Hedging 135

7.5 Strategy: Volatility Skew—Long Risk Reversal 135

7.6 Strategy: Volatility Trading with Variance Swaps 136

References 137

8 Foreign Exchange (FX) 143

8.1 Strategy: Moving Averages with HP Filter 143

8.2 Strategy: Carry Trade 144

Strategy: High-minus-low Carry 145

8.3 Strategy: Dollar Carry Trade 146

8.4 Strategy: Momentum and Carry Combo 147

8.5 Strategy: FX Triangular Arbitrage 147

References 148

9 Commodities 155

9.1 Strategy: Roll Yields 155

9.2 Strategy: Trading Based on Hedging Pressure 156

9.3 Strategy: Portfolio Diversification with Commodities 156

9.4 Strategy: Value 157

9.5 Strategy: Skewness Premium 157

9.6 Strategy: Trading with Pricing Models 158

References 159

10 Futures 165

10.1 Strategy: Hedging Risk with Futures 165

Strategy: Cross-Hedging 165

Strategy: Interest Rate Risk Hedging 166

10.2 Strategy: Calendar Spread 167

10.3 Strategy: Contrarian Trading (Mean-Reversion) 168

Strategy: Contrarian Trading—Market Activity 168

10.4 Strategy: Trend Following (Momentum) 169

References 171

11 Structured Assets 181

11.1 Generalities: Collateralized Debt Obligations (CDOs) 181

11.2 Strategy: Carry, Equity Tranche—Index Hedging 183

11.3 Strategy: Carry, Senior/Mezzanine—Index Hedging 183

11.4 Strategy: Carry—Tranche Hedging 184

11.5 Strategy: Carry—CDS Hedging 184

11.6 Strategy: CDOs—Curve Trades 184

11.7 Strategy: Mortgage-Backed Security (MBS) Trading 185

References 186

12 Convertibles 193

12.1 Strategy: Convertible Arbitrage 193

12.2 Strategy: Convertible Option-Adjusted Spread 194

References 195

13 Tax Arbitrage 199

13.1 Strategy: Municipal Bond Tax Arbitrage 199

13.2 Strategy: Cross-Border Tax Arbitrage 199

Strategy: Cross-Border Tax Arbitrage with Options 201

References 201

14 Miscellaneous Assets 205

14.1 Strategy: Inflation Hedging—Inflation Swaps 205

14.2 Strategy: TIPS-Treasury Arbitrage 206

14.3 Strategy: Weather Risk—Demand Hedging 207

14.4 Strategy: Energy—Spark Spread 209

References 210

15 Distressed Assets 219

15.1 Strategy: Buying and Holding Distressed Debt 219

15.2 Strategy: Active Distressed Investing 220

Strategy: Planning a Reorganization 220

Strategy: Buying Outstanding Debt 220

Strategy: Loan-to-own 220

15.3 Strategy: Distress Risk Puzzle 220

Strategy: Distress Risk Puzzle—Risk Management 221

References 222

16 Real Estate 229

16.1 Generalities 229

16.2 Strategy: Mixed-Asset Diversification with Real Estate 230

16.3 Strategy: Intra-asset Diversification Within Real Estate 230

Strategy: Property Type Diversification 230

Strategy: Economic Diversification 231

Strategy: Property Type and Geographic Diversification 231

16.4 Strategy: Real Estate Momentum—Regional Approach 231

16.5 Strategy: Inflation Hedging with Real Estate 232

16.6 Strategy: Fix-and-flip 232

References 233

17 Cash 241

17.1 Generalities 241

17.2 Strategy: Money Laundering—The Dark Side of Cash 241

17.3 Strategy: Liquidity Management 242

17.4 Strategy: Repurchase Agreement (REPO) 242

17.5 Strategy: Pawnbroking 243

17.6 Strategy: Loan Sharking 243

References 243

18 Cryptocurrencies 249

18.1 Generalities 249

18.2 Strategy: Artificial Neural Network (ANN) 250

18.3 Strategy: Sentiment Analysis—Naïve Bayes Bernoulli 254

References 256

19 Global Macro 263

19.1 Generalities 263

19.2 Strategy: Fundamental Macro Momentum 263

19.3 Strategy: Global Macro Inflation Hedge 264

19.4 Strategy: Global Fixed-Income Strategy 265

19.5 Strategy: Trading on Economic Announcements 265

References 265

20 Infrastructure 269

References 270

Appendix A: R Source Code for Backtesting 275

Appendix B: Disclaimers 285

Glossary 287

Bibliography 351

Explanatory Comments for Index 459

Index 461