The Option Value in Timing Derivative Trades

Abstract

Risk-neutral traders executing derivative trades on behalf of portfolio managers maximize their expected profit compared to trading at pre-determined times by timing trades, using the quickly changing risk exposures of derivative baskets. The optimal order submission strategy is a sequence of stop orders with a time-varying stop price. Timing a straddle trade yields up to 20bps per day in a frictionless world, and up to 72bps per day on the S&P500. A CRRA trader is willing to pay up to 51bps of the value of the derivatives to switch from trading at a fixed time to the optimal timing strategy.

Keywords: derivatives trading, execution timing, optimal stopping, dynamic programming, straddles, dynamic order strategies

JEL Classification: G11, G13