Currently I'm trying to test the efficacy of a tail-hedging strategy in which an investor goes long in an index and correspondingly buys 1-month OTM put options. For practical reasons, the options with the particular strike price that we buy each month must be liquid. My dilemma is in how exactly do I define the filters used to select the strike price.

Currently, there are 2 filters - open interest and the strike price itself:

1) Strike price - Suppose $K$ is 5% of the underlying price rounded to the nearest 100. Then the strike price is $K$ if the corresponding options are liquid, $K-100$ if $K$ isn't liquid, and $K+100$ if neither $K$ nor $K-100$ are liquid. No option purchased if none of them is liquid.

2) Open interest - A strike price with an open interest of at least 1000000 contracts is considered liquid.

Now the main problem is that the above definition of a liquid option is really vague. I read that it's a huge mistake to randomly vary or not properly define the parameters, and then to rely on the results of such a backtest. I'm testing this strategy for the Indian market, wherein option trading picked up from 2009 onwards (i.e., more liquid options were available) according to my project guide. This introduces another problem - I don't have enough data points to perform both backtesting and forward-testing.

So with all of the above background info in mind, how do I come up with a concrete definition of what a "liquid" strike price should be? Sure I can relax the definition and that way I'll have even more data points available from 2006 onward, but wouldn't that just be reckless overfitting?

Thanks in advance

  • 1
    $\begingroup$ No, open interest is not enough to know if it is liquid or not. You also need to analyze the spread between bid and ask (ie lower the spread the more liquid it is) $\endgroup$ – Ariel Silahian May 13 '16 at 4:46
  • $\begingroup$ @ArielSilahian: In that case I'll need to put a constraint on the bid-ask spread too. But again, it will boil down to the same problem as for open interest - exactly how to define the upper bound on the bid-ask spread. $\endgroup$ – u23 May 13 '16 at 5:05
  • $\begingroup$ Get the advice of some experienced trader on what a "decent" OI and Volume is to ensure liquidity. (1000000 contracts sounds huge to me). $\endgroup$ – noob2 May 13 '16 at 12:16

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