Option straddle trading: Financial performance and economic significance of direct profit forecast and conventional strategies

Abstract

The present study focuses on the trading of at-the-money straddles using options on foreign currency futures, namely British Pound, Canadian Dollar, and Japanese Yen. The financial performance and economic significance of a direct profit forecast trading strategy are examined. This strategy uses a linear projection to directly forecast the profit (net of transaction costs) of engaging in a straddle. The straddle is purchased when the forecast is positive and sold when negative. This differs from the conventional option trading strategy of basing trading decisions on a two-step procedure of first generating a volatility forecast and then inputting the volatility forecast into an appropriate option pricing model to price the straddle. The direct profit forecast trading strategy removes volatility forecasting and option pricing models from the straddle trading decision process altogether. This method has only one source of model risk, compared to the conventional two step method which has two sources of model risk. It is possible that the direct forecast trading strategy with only one source of model risk may outperform the conventional method of trading straddles. The experimental investigation confirms this notion and the out-of-sample results indicate that, for each of the currencies analysed, the direct forecasting strategy is more profitable than the conventional two-step method. Furthermore, the results are robust with respect to different transaction cost assumptions. Finally, tests of economic significance indicate consistent market timing value for the direct forecast method.