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Design and Back-Testing of a Systematic Delta-Hedging Strategy in FX Options Space

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Design and Back-Testing of a Systematic Delta-Hedging Strategy in FX Options Space” offers a detailed examination of an automated delta-hedging strategy tailored to short-dated fx options, specifically the weekly and monthly at-the-money EURUSD straddles.

The results reveal the potential for generating financial gain through the systematic sale of delta-hedged options, boasting an attractive Sharpe ratio exceeding 3.0 on an after-cost basis.

Notably, the strategy’s performance is intricately linked to the day of the week, shedding light on the nuanced timing required for optimal execution.

Additionally, the strategy’s uncorrelated performance with linear changes in spot price aligns with the Black-Scholes theory, adding to the complexity and depth of this analysis. This study presents a compelling exploration of statistical arbitrage, algorithmic trading, and volatility within the FX options domain.

Abstract Of Paper

This paper describes design and back-testing of an automated delta-hedging strategy applied to short-dated fx options (specifically – weekly and monthly at-the-money EURUSD straddles).

The results indicate that systematic sale of options that are delta-hedged according to the suggested algorithm generates financial gain for the seller with an attractive Sharpe ratio exceeding 3.0 on after-cost basis (back-testing accounts for volatility bid-offer as well as spot market bid-offer).

For weekly options Sharpe ratio significantly depends on the day of week on which the algorithm systematically sells options: delta-hedging of options sold on Thursdays results in highest Sharpe ratio; delta-hedging of options sold on Fridays results in second-best Sharpe ratio.

The performance of the algorithmic strategy is not correlated with linear changes in spot price which is in line with Black-Scholes theory.

The proposed algorithmic strategy has just a few parameters which serves as a natural protection against over-fitting bias. Further fine-tuning of the algorithm requires access to historical data over longer period and/or access to live trading environment.

Original paper – Download PDF

Here you can download the PDF and original paper of Design and Back-Testing of a Systematic Delta-Hedging Strategy in FX Options Space.

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Author

Valery Sorokin
Independent

Conclusion

In conclusion, the examination of the automated delta-hedging strategy in the FX options space has unearthed a plethora of insights into its potential for generating financial gain.

The remarkable Sharpe ratio exceeding 3.0 on an after-cost basis stands as a testament to the strategy’s efficacy, fostered by meticulous back-testing that accounts for volatility bid-offer and spot market bid-offer.

The day-of-week dependency of the Sharpe ratio for weekly options adds a layer of nuanced sophistication and tactical significance to the strategic execution of this algorithm.
Moreover, the strategy’s uncorrelated performance with linear changes in spot price aligns seamlessly with the tenets of the Black-Scholes theory, underlying its robustness and theoretical soundness.

As a natural safeguard against over-fitting bias, the strategy’s few parameters serve as a promising foundation for further refinement, warranting comprehensive historical data and the live trading environment for future fine-tuning and validation.

This study has illuminated intricate facets of statistical arbitrage, algorithmic trading, and volatility within the FX options domain, inviting profound contemplation and exploration within this captivating arena.

Related Reading:

ANANTA: A Systematic Quantitative FX Trading Strategy

Beyond the Carry Trade: Optimal Currency Portfolios

FAQ

Q1: What is the key result of the back-testing of the systematic delta-hedging strategy in FX options space?

A1: The back-testing indicates that the systematic sale of options delta-hedged according to the suggested algorithm generates financial gain for the seller, boasting an attractive Sharpe ratio exceeding 3.0 on an after-cost basis.

Q2: How does the day of the week impact the performance of the delta-hedging strategy for weekly options, and which day yields the highest Sharpe ratio?

A2: The performance of the strategy for weekly options significantly depends on the day of the week. Delta-hedging options sold on Thursdays results in the highest Sharpe ratio, while options sold on Fridays yield the second-best Sharpe ratio.

Q3: What is noteworthy about the strategy’s correlation with linear changes in spot price, and how does it align with the Black-Scholes theory?

A3: The strategy’s uncorrelated performance with linear changes in spot price aligns with the Black-Scholes theory, adding theoretical soundness and robustness to its design. This characteristic reflects the strategy’s alignment with the core principles of options pricing theory.

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