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Inventory-Based Versus Prior-Based Options Trading Agents

28 Pages Posted: 5 Oct 2012 Last revised: 16 Oct 2012

Abraham Othman

University of Pennsylvania - Operations & Information Management Department

Tuomas Sandholm

Carnegie Mellon University - School of Computer Science

Date Written: October 3, 2012

Abstract

Options are a basic, widely-traded form of financial derivative that offer payouts based on the future price of an underlying asset. The finance literature gives us option-trading algorithms that take into consideration information about how prices move over time but do not explicitly involve the trades the agent made in the past. In contrast, the prediction market literature gives us automated market-making agents (like the popular LMSR) that are event-independent and price trades based only on the inventories the agent holds. We simulate the performance of five trading agents inspired by these literatures on a large database of recent historical option prices. We find that a combination of the two approaches produced the best results in our experiments: a trading agent that keeps track of previously-made trades combined with a good prior distribution on how prices move over time. The experimental success of this synthesized trader has implications for agent design in both financial and prediction markets.

Suggested Citation

Othman, Abraham and Sandholm, Tuomas, Inventory-Based Versus Prior-Based Options Trading Agents (October 3, 2012). Algorithmic Finance (2012), 1:2, 95-121. Available at SSRN: https://ssrn.com/abstract=2156210

Abraham Othman (Contact Author)

University of Pennsylvania - Operations & Information Management Department ( email )

Philadelphia, PA 19104
United States

Tuomas Sandholm

Carnegie Mellon University - School of Computer Science ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213
United States

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