Quant Mashup - Relative Value Arbitrage Volatility Targeting Across Asset Pricing Factors and Industry Portfolios [Relative Value Arbitrage] Tail Risk Hedging Using Option Signals and Bond ETFs [Relative Value Arbitrage]Tail risk hedging plays a critical role in portfolio management. I discussed this topic in a previous article. In this post, I continue the discussion by presenting different techniques for managing tail risks. Hedging with Puts: Do Volatility and Skew Signals Work? Portfolio hedging remains a(...) Stochastic Volatility Models for Capturing ETF Dynamics and Option Term Structures [Relative Value Arbitrage]The standard Black-Scholes-Merton model is valuable in both theory and practice. However, in certain situations, more advanced models are preferable. In this post, I explore stochastic volatility models. Stock and Volatility Simulation: A Comparative Study of Stochastic Models Stochastic volatility(...) Cross-Sectional Momentum: Results from Commodities and Equities [Relative Value Arbitrage]Momentum strategies can be divided into two categories: time series and cross-sectional. In a previous newsletter, I discussed time series momentum. In this post, I focus on cross-sectional momentum strategies. Cross-Sectional Momentum in the Commodity Market Momentum trading is often divided into 2(...) Predictive Information of Options Volume in Equity Markets [Relative Value Arbitrage]A lot of research in options literature has been devoted to the volatility risk premia and developing advanced pricing models. Much less attention has been given to volume. In this post, I’ll discuss some aspects of options volume. Can Options Volume Predict Market Returns? Most of the research in(...) The Impact of Market Regimes on Stop Loss Performance [Relative Value Arbitrage]Stop loss is a risk management technique. It has been advocated as a way to control portfolio risk, but how effective is it? In this post, I will discuss certain aspects of stop loss. When Are Stop Losses Effective? A stop loss serves as a risk management tool, helping investors limit potential(...) The Limits of Out-of-Sample Testing [Relative Value Arbitrage]In trading system design, out-of-sample (OOS) testing is a critical step to assess robustness. It is a necessary step, but not sufficient. In this post, I’ll explore some issues with OOS testing. How Well Overfitted Trading Systems Perform Out-of-Sample? In-sample overfitting is a serious problem(...) Sentiment as Signal: Forecasting with Alternative Data and Generative AI [Relative Value Arbitrage]Quantitative trading based on market sentiment is a less developed area compared to traditional approaches. With the explosion of social media, advances in computing resources, and AI technology, sentiment-based trading is making progress. In this post, I will explore some aspects of sentiment(...) Behavioral Biases and Retail Options Trading [Relative Value Arbitrage]Why Do Investors Lose Money? Behavioral finance is the study of how financial behavior affects economic decisions and market outcomes, and how those decisions and outcomes are affected by psychological, social, and cultural factors. Behavioral finance research has shown that people do not always(...) The Rise of 0DTE Options: Cause for Concern or Business as Usual? [Relative Value Arbitrage]Zero DTE (Days to Expiration) options are contracts that expire on the same day they are traded. They were introduced in 2022 and have been gaining popularity. In this post, I discuss their impact on the market and how options traders use them. Impact of Zero DTE Options on the Market Zero DTE(...) How Machine Learning Enhances Market Volatility Forecasting Accuracy [Relative Value Arbitrage]Machine learning has many applications in finance, such as asset pricing, risk management, portfolio optimization, and fraud detection. In this post, I discuss the use of machine learning in forecasting volatility. Using Machine Learning to Predict Market Volatility The unpredictability of the(...) Predicting Corrections and Economic Slowdowns [Relative Value Arbitrage]Being able to anticipate a market correction or an economic recession is important for managing risk and positioning your portfolio ahead of major shifts. In this post, we feature two articles: one that analyzes indicators signaling a potential market correction, and another that examines recession(...) Rethinking Leveraged ETFs and Their Options [Relative Value Arbitrage]A leveraged Exchanged Traded Fund (LETF) is a financial instrument designed to deliver a multiple of the daily return of an underlying index. Despite criticism, LETFs are frequently used by institutional investors. In this post, I discuss the practicality of LETFs and show that they are not as risky(...) Using Skewness and Kurtosis to Enhance Trading and Risk Management [Relative Value Arbitrage]Skewness is a measure of the asymmetry of a return distribution. In this post, I’ll discuss the skewness risk premium and how skewness can be used to forecast realized volatility. Skewness Risk Premium in the Options Market Skewness of returns is a statistical measure that captures the asymmetry(...) Gold Ratios as Stock Market Predictors [Relative Value Arbitrage]The ratio of gold prices to other asset classes has been shown to be a useful predictor of stock market returns. In this post, we discussed several gold-based ratios and how they can be used to forecast equity market performance. Gold Oil Price Ratio As a Predictor of Stock Market Returns Analyzing(...) Volatility of Volatility: Insights from VVIX [Relative Value Arbitrage]The volatility of volatility index, VVIX, is a measure of the expected volatility of the VIX index itself. In this post, we will discuss its dynamics, compare it with the VIX index, and explore how it can be used to characterize market regimes. Dynamics of the Volatility of Volatility Index, VVIX(...) Simplicity or Complexity? Rethinking Trading Models in the Age of AI and ML [Relative Value Arbitrage]When it comes to trading system design, there are two schools of thought: one advocates for simpler rules, while the other favors more complex ones. Which approach is better? This newsletter explores both perspectives through the lens of machine learning. Use of Machine Learning in Pairs Trading(...) Low-Volatility Stocks: Reducing Risk Without Sacrificing Returns [Relative Value Arbitrage]The recent market turbulence highlights the need for improved risk management and strategies to reduce portfolio volatility. In this post, I’ll explore how to enhance portfolio diversification using low-volatility stocks. Gold and Low-Volatility Stocks as Diversifiers Gold has long been regarded(...) The Calendar Effects in Volatility Risk Premium [Relative Value Arbitrage]I recently covered calendar anomalies in the stock markets. Interestingly, patterns over time also appear in the volatility space. In this post, I’ll discuss the seasonality of volatility risk premium (VRP) in more detail. Breaking Down the Volatility Risk Premium: Overnight vs. Intraday Returns(...) Stock-Bond Correlation: What Drives It and How to Predict It [Relative Value Arbitrage]The correlation between stocks and bonds plays a crucial role in portfolio allocation and diversification strategies. In this issue, I discuss stock-bond relationships, the factors that influence their correlation, and techniques for forecasting it. What Influences Stock-Bond Correlation?(...) Machine Learning in Financial Markets: When It Works and When It Doesn’t [Relative Value Arbitrage]Machine learning (ML) has made a lot of progress in recent years. However, there are still skeptics, especially when it comes to its application in finance. In this post, I will feature articles that discuss the pros and cons of ML. In future editions, I’ll explore specific techniques. How(...) Do Calendar Anomalies Still Work? Evidence and Strategies [Relative Value Arbitrage]nd Strategies Subscribe to newsletter Calendar anomalies in the stock market refer to recurring patterns or anomalies that occur at specific times of the year, month, or week, which cannot be explained by traditional financial theories. These anomalies often defy the efficient market hypothesis and(...) Catastrophe Bonds: Modeling Rare Events and Pricing Risk [Relative Value Arbitrage]A catastrophe (CAT) bond is a debt instrument designed to transfer extreme event risks from insurers to capital market investors. They’re important for financial institutions, especially insurers and reinsurers, because they offer a way to manage large, low-probability. In this post, I feature(...) Breaking Down Volatility: Diffusive vs. Jump Components [Relative Value Arbitrage]Implied volatility is an important concept in finance and trading. In this post, I further discuss its breakdown into diffusive volatility and jump risk components. Decomposing Implied Volatility: Diffusive and Jump Risks Implied volatility is an estimation of the future volatility of a security’s(...) Crypto Market Arbitrage: Profitability and Risk Management [Relative Value Arbitrage]Cryptocurrencies are becoming mainstream. In this post, I feature some strategies for trading and managing risks in cryptocurrencies. Arbitrage Trading in the Cryptocurrency Market Arbitrage trading takes advantage of price differences in different markets and/or instruments. Reference [1] examined(...) Optimizing Portfolios: Simple vs. Sophisticated Allocation Strategies [Relative Value Arbitrage]Portfolio allocation is an important research area. In this issue, we explore not only asset allocation but also the allocation of strategies. Specifically, I discuss tactical asset and trend-following strategy allocation. Tactical Asset Allocation: From Simple to Advanced Strategies Tactical Asset(...) Capturing Volatility Risk Premium Using Butterfly Option Strategies [Relative Value Arbitrage]The volatility risk premium is a well-researched topic in the literature. However, less attention has been given to specific techniques for capturing it. In this post, I’ll highlight strategies for harvesting the volatility risk premium. Long-Term Strategies for Harvesting Volatility Risk Premium(...) Understanding Mean Reversion to Enhance Portfolio Performance [Relative Value Arbitrage]In a previous newsletter, I discussed momentum strategies. In this edition, I’ll explore mean-reverting strategies. Mean reversion is a natural force observed in various areas of life, including sports performance, portfolio performance, volatility, asset prices, etc. In this issue, I specifically(...) Volatility Risk Premium: The Growing Importance of Overnight and Intraday Dynamics [Relative Value Arbitrage]The breakdown of the volatility risk premium into overnight and intraday sessions is an active and emerging area of research. It holds not only academic interest but also practical implications. ETF issuers are launching new ETFs to capitalize on the overnight risk premium, and the shift toward(...) Exploring Credit Risk: Its Influence on Equity Strategies and Risk Management [Relative Value Arbitrage]Credit risk, also known as default risk, is the likelihood of loss when a borrower or counterparty fails to meet its obligations. A lot of research has been conducted on credit risk, and an emerging line of study explores the connection between the equity and credit markets. In this post, we’ll(...) Hedging Efficiently: How Optimization Improves Tail Risk Protection [Relative Value Arbitrage]Tail risk hedging aims to protect portfolios from extreme market downturns by using strategies such as out-of-the-money options or volatility products. While effective in mitigating large losses, the challenge lies in balancing cost and long-term returns. In this post, we’ll discuss tail risk(...) Momentum Strategies: Profitability, Predictability, and Risk Management [Relative Value Arbitrage]Momentum strategies have long been a cornerstone of investing, relying on the premise that past winners continue to outperform in the near future. This post explores the effectiveness of momentum strategies, analyzing their ability to generate abnormal returns and assessing their viability in(...) The Predictive Power of Dividend Yield in Equity Markets [Relative Value Arbitrage]Dividend yield has long been a cornerstone of equity valuation. In this post, we explore how dividend yield predicts stock returns, its impact on stock volatility, and why it holds unique significance for mature, dividend-paying firms. Relationship Between Implied Volatility and Dividend Yield(...) Monte Carlo Simulations: Pricing Weather Derivatives and Convertible Bonds [Relative Value Arbitrage]Monte Carlo simulations are widely used in science, engineering, and finance. They are an effective method capable of addressing a wide range of problems. In finance, they are applied to derivative pricing, risk management, and strategy design. In this post, we discuss the use of Monte Carlo(...) PCA in Action: From Commodity Derivatives to Dispersion Trading [Relative Value Arbitrage]Principal Component Analysis (PCA) is a dimensionality reduction technique used to simplify complex datasets. It transforms the original variables into a smaller set of uncorrelated variables called principal components, ranked in order of their contribution to the dataset’s total variance. In(...) CAPM, WACC, and Beyond: Beta’s Application in Arbitrage [Relative Value Arbitrage]Beta is a measure of an asset’s sensitivity to market movements, indicating how much its price is expected to change in relation to the overall market. Beta is often used in CAPM and the calculation of WACC. However, it can also be applied in trading, specifically in arbitrage. In this post,(...) From Gold to Bitcoin: Exploring the Oldest and Newest Asset Classes [Relative Value Arbitrage]Gold, one of the oldest and most enduring asset classes, had an exceptional run in 2024, capturing attention across financial markets. Its role in investment portfolios continues to spark interest, acting as a hedge against uncertainty. On the other end of the spectrum, cryptocurrencies represent(...) Option Pricing Models and Strategies for Crude Oil Markets [Relative Value Arbitrage]Financial models and strategies are usually universal and can be applied across different asset classes. However, in some cases, they must be adapted to the unique characteristics of the underlying asset. In this post, I’m going to discuss option pricing models and trading strategies in(...) When Correlations Break or Hold: Strategies for Effective Hedging and Trading [Relative Value Arbitrage]It’s well known that there is a negative relationship between an equity’s price and its volatility. This can be explained by leverage or, alternatively, by volatility feedback effects. In this post, I’ll discuss practical applications to exploit this negative correlation between equity prices(...) Hurst Exponent Applications: From Regime Analysis to Arbitrage [Relative Value Arbitrage]One of my favourite ways to characterize the market regime is by using the Hurst exponent. However, its applications are not limited to identifying market regimes. There are innovative ways to utilize it. In this post, I will discuss two approaches to applying the Hurst exponent. Using the Hurst(...) Examining Contango and Backwardation in VIX Futures [Relative Value Arbitrage]In this post, I will continue exploring various aspects of the volatility index and the associated volatility futures. Data To conduct this study, data is essential. Below are the data sources: Spot VIX: Yahoo Finance provides data but no longer allows direct downloads. With some programming, a(...) Making Use of Information Embedded in VIX Futures Term Structures [Relative Value Arbitrage]Building on the first paper, Reference [2] investigates machine learning techniques for trading VIX futures. It proposed using Constant Maturity Futures (CMF) to generate trading signals for VIX futures. It applied machine learning models to create these signals. Findings The experiment results show(...) Rethinking Pairs Trading: Can Traditional Methods Still Deliver Returns? [Relative Value Arbitrage]Pairs trading is a market-neutral strategy that involves trading two correlated stocks or assets. The idea is to identify pairs that historically move together, and then take a long position in one and a short position in the other when they diverge, with the expectation that they will eventually(...) The Weekend Effect in the Market Indices [Relative Value Arbitrage]The weekend (or Monday) effect in the stock market refers to the phenomenon where stock returns exhibit different patterns on Mondays compared to the rest of the week. Historically, there has been a tendency for stock prices to be lower on Mondays. Various theories attempt to explain the weekend(...) Which System Has The Lowest Risk of Ruin? [Relative Value Arbitrage]Would you rather choose a trading system that wins small amounts most of the time but when it loses, the loss is big? Or would you rather choose a trading system that loses small amounts most of the time but when it wins, the gain is big? In this blog post, we will examine such systems from the risk(...) Asset Price Dynamics and Trading Strategy's PnL Volatility [Relative Value Arbitrage]In a previous post, we discussed how the dynamics of assets are priced in the options prices. We recently came across a newly published article [1] that explored the same topic but from a different perspective that does not involve options. The conclusion of the new article [1] is consistent with(...) Correlation Between the VVIX and VIX indices [Relative Value Arbitrage]The VIX index is an important market indicator that everyone is watching. VVIX, on the other hand, receives less attention. In this post, we are going to take a look at the relationship between the VIX and VVIX indices. While the VIX index measures the volatility risks, VVIX measures the(...) Differences Between the VIX Index And At-the-Money Implied Volatility [Relative Value Arbitrage]When trading options, we often use the VIX index as a measure of volatility to help enter and manage positions. This works most of the time. However, there exist some differences between the VIX index and at-the-money implied volatility (ATM IV). In this post, we are going to show such a difference(...) Is Asset Dynamics Priced In Correctly by Black-Scholes-Merton Model? [Relative Value Arbitrage]A lot of research has been devoted to answering the question: do options price in the volatility risks correctly? The most noteworthy phenomenon (or bias) is called the volatility risk premium, i.e. options implied volatilities tend to overestimate future realized volatilities. Much less attention(...) A Simple Hedging System With Time Exit [Relative Value Arbitrage]This post is a follow-up to the previous one on a simple system for hedging long exposure during a market downturn. It was inspired by H. Krishnan’s book The Second Leg Down, in which he referred to an interesting research paper [1] on the power-law behaviour of the equity indices. The paper(...)