Building Algorithm By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

June 6, 2016 | Posted by bobbysrinivasan << back to blog

An example of building an algorithm for trading: Gold. Among all the commodities that are traded both Gold and Crude oil fascinated me. So since I trade them I thought it would be interesting to share my knowledge and experience with you. The reasons for selection of these commodities are as follow,

Gold and Crude oil are traded both physically and in an exchange. Manipulating their prices is not easy. There is no insider trading at all.
Intervention by the governments in the price discovery process exists; however you only see government buying gold as part of their foreign reserve and oil is often bought and stored for country’s strategic inventory.
There is huge interest in these commodities all over the world namely governments, traders, speculators are all in the game.
If a long term trend is identified a huge fortune can be made from the market price movements. After the Bretton woods agreement failure in 1971 (present Richard Nixon devalued US dollar by 20%) gold price went from $ 35 an ounce to $ 150 an ounce. The author used this opportunity to create wealth for himself.

Now let us turn our attention to trading gold. These are the following basic facts,

Gold future options are traded regularly while futures are available for several months in a year. Options are available for every month in CME.
The number of trading days in a month is approximately 22 working days.
Selling options require margin. For a serious trader, it is not so important.
Price during the 22 days are affected by the following major factors,
Non-farm payroll: Every month US releases data on job creation. If the number of jobs created is more than expected the price of gold will fall and vice versa. Normally the drop will be 2 to 3% of value.
GDP growth rate: Every 3 months US announces GDP growth, but keep changing their estimates upward or downward. For example, the first quarter 2016 GDP was announced as 0.45%. This is bad news for the dollar and good news for gold.

CPI and PPI at this juncture are not of any relevance because inflation has been relatively flat for a very long time.

Consumer confidence: If it is high, it is not good news for gold. If it is low people rush to buy gold.

So given the historical data of the last month one has to do some mental arithmetic and decide how the future price of gold will move and possible size of volatility.

Action

When the GDP was announced it was quite clear that the dollar will weaken and that the gold price is likely to move up. So being used to trading I sold puts at the level. I felt that the price level will not drop in the next 22 days. Similarly I sold the call above 40 to 50 dollars from the spot. The result was

Gold floor closing price for option settlement for April was $ 1244

I sold a 1200 Put (2 of them)

1210 Put (2 of them)

1230 Call (2) of them

1290 Call (2) of them

I received a total premium of $ 6500. The whole idea is to keep both the premium. Last month yielded $ 5360 and the price of gold stayed in the same range.

Results: Astonishing results with 20000 to 25000 dollar margin a net return of $ 5000 or more was possible. This is 20% return per month and more than 250% for the whole month.

Conclusion:

Experience shows how the prices of gold generally move and how rapidly it moves. Even in these 22 days of trading we can find 10 days where no worthwhile data is coming. During such periods the price will remain relatively stagnant and the option premium for the positions will come down. So a trader can buy back his open positions and still make a good profit.

So in this case the algorithm is the rule to trade and how to trade to your advantage contrary to opinion that price movements are random one could easily develop an algorithm which if employed will result in a profit.

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