Musings on Put Credit Spreads (Part 1)

The biggest problem I have with naked puts is the inability to defend them in a market crash. Studying the last 15 years has given me great perspective in terms of drawdowns (DD). I must always expect a worse DD in the future, though, and it does seem like we’re seeing historic “worsts” on a semi-regular basis. The latest included two IV-popping 10+% corrections in the span of five months (Sep 2015, Jan 2016), which is a first for the 15-year time interval.

My concern about naked puts is their undefined risk nature. This means the theoretical worst could be a whole lot worse than anything ever seen. For this reason, I would definitely limit naked puts to a percentage of the total portfolio. I also find it promising to cut position size based on some sort of bull/bear regime change.

Further study is needed to determine whether a regime change would actually help. Anecdotally, significant profits seem to accrue when the market is below an X-day moving average (MA). I suspect the sharpest losses also occur below an X-day MA, though, so it may or may not make sense to limit exposure based on regime. Given my druthers, I would sacrifice profits for DD improvement and trade a smoother equity curve in larger size. This may result in a greater overall net profit.

The real kicker is that I believe position size should be held constant in trading system development. Varying position size complicates DD analysis of the equity curve because some will be apples and others will be oranges.

My study of naked puts is not complete as of the time of this writing. My last backtest fixed short delta rather than premium collected and I need to analyze those data. I am waiting to include February expiration, which has losses from the most recent market correction.

Also holding me up are the concerns described above. To that end, trading put verticals is very tempting to take the “undefined” out of undefined risk. I will continue this deliberation next time.