Trading Strategies Based on the Heston Model

The main goal of this study is to construct and test a trading strategy that uses Heston model to predict option prices. By analyzing traditional calibration approaches, hypotheses for improving the calibration process were put forward and confirmed using specific examples of stock options on Intel and Apple. In particular, using IV as a way to normalize price differences appears to improve calibration accuracy, and using spot information appears to improve consistency of the process. Final method allows to achieve MAPE of no more than 3% on a daily data of Intel and Apple. Based on this method and the idea of «trading interest» trimming, a trading strategy for near-the-money options was built. Backtesting over 12 years of day trading shows that the strategy has a Sharpe ratio of 2.63 and 1.14 for options on Intel and Apple stock, respectively. The study shows how important it is to choose the correct Heston model calibration specification in order to obtain reliable results.