I am inclined to believe that stat arb does exist, but it's incredibly, incredibly rare... and it's certainly nothing as simple as buying or selling a put/call/calendar/butterfly spread. To have actual statistical "edge" that you can arb, you need a better-than-average continuous model for price and volatility. To put it mildly, it's more or less the holy grail. For the vast majority of option traders... we're fundamentally no different than stock traders. The shape of the payoff function looks a little different, but the ultimate risk/reward ratio over time will look the same.
I have been working on a philosophical argument that I think shows that any option strategy that does not involve predicting market direction (or at least expiration day ending price) losses money. My observation is that outcomes from the following thought experimental will fail any kind of spectral test, i.e. there will be no random variation. At the current month's expiration buy or sell the nearest strike straddle. At the next months expiration, underlying price will be manipulated to be exactly evenly distributed (ignore dividends, interest costs, etc.). Namely, there will be no 'statistical variation' even over a small number of samples. In its simplest form, exactly half of the closing prices will be less and half greater. In a random set of trials there should be much more variation. I thought of this in trying to explain why I think the various Cottle type straddle/strangle trades can't make money. I think this shows that statistics is a nonsense concept like signs of the Zodiac. One's Zodiac sign has some predictive power providing society believes in it as a convention. There are two cases. Statistics involving infinity is nonsense since no operations can be defined for infinite sets. Statistics is just conventions and axioms here. The ignored 20th century logician Paul Finsler showed this. The only algebraic operation that makes sense for infinite sets is one-to-one correspondence making. The other case is finite experiments involving human society. I think the right analogy for seeing option trades is to see a fixed dice game. The dice are magnetized and everybody has a magnet some small and some large. Market makers basically have the advantage of seeing retail magnets but no magnet of their own. The Tarp banks have both better viewing of magnets and large magnets themselves. This makes statistics and the various theorems pure fantasy. This also shows that no retail trader can make money even if trading costs are ignored from non price change predicting option trades - any option strategy that does not make a directional prediction will lose money. It also suggests that market makers can't make money unless their profit is tolerated by the vertically integrated and now Tarp receiving large magnet holding money center banks. ~
this is where your assumption is wrong. The distribution of the underlying prices is NOT normal. That is one of the most fundamental issues in options trading. And this is where some of the models have the edge. Options are priced according to which probabilities the market for up and down moves implies. Those probabilities are pretty much always skewed. If you model disagrees with this skew with a statistical edge then you have a strategy with edge. Those are just some very basic observations after having traded options for institutional outlets for years.
I like to add that another factor that may differentiate retail from professional traders is capitalization. I would assert that pure vol trading strategies for a retail guy/gal are impossible without at least putting USD 1 million on the line.
...there is no guaranteed way to make money, no matter what. So even being able to buy options below fair value and selling those above fair value can lose you money. The reasons can be many, among others, liquidity issues, overleverage, commission, and so forth. While the identification of fair value and deviations of that is the right approach many other issues need to be considered.
Everything that you say may be totally true but extensive programming and extensive development skills aren't usually within the purview of most of the retail world which has not spent their professional life in the pits, at prop desks or in related industry positions. Ergo, we end up doing things a bit differently.
You seem to forget that option contracts are merely created by a shake of hands of two willing parties--whereas, the equity market presumably reflects some precieve valuations. ~B
I think everyone has touched on great points. Selecting strategy appropriate to the environment and managing it is the "edge." Let's suppose you believe the S&P 500 E-mini will go down a hundred points. Now the key is to select and manage your strategy. One, you would like to pick the strategy that gives you optimum profit. Since you know what is going to happen, there can be no loss (or can there be?). It looks like the best trade would be to short the futures. Now, let's suppose we always use options in our trading. So, let's say we use the covered put strategy (short the futures and sell the ATM put). Your profit will be about 60 points. Bear put spreads and bear call spreads will work, but not make as much. A DOTM bull put spread will make even less. Interestingly, if you do a long put, you could actually lose money, for the market takes too long to go down. So, we are back to strategy--picking the right one and managing it.
I personally doubt there's much alpha left in trying to arb the volatility surface. Everyone has pretty much the same option pricing models, and everything tends to move in line.