Musings on Put Credit Spreads (Part 2)

Last time I summarized my progress analyzing naked puts and addressed my biggest concern. One possible antidote to undefined risk is an option spread but backtesting spreads presents an array of challenges.

The simplest spreads are vertical or horizontal. Beyond that, we have:

• Diagonals
• Butterflies
• Iron Condors
• Double Diagonals (i.e. “Straddle-Strangle Swap”)
• Ratio Backspreads

A complex spread is a combination of simple spreads and/or a single option(s). For backtesting purposes, I wonder whether the separate legs must be combined as they were historically or whether this is too deterministic. In case of the latter, I should randomize the combinations and study a simulation of many more possibilities in true Monte Carlo style.

I’m talking a violent disruption to the conventional order, here…

Thankfully, I believe price interaction is a decent argument for keeping historical spreads intact. For example, consider a liquid put vertical spread that is one strike wide. With 30 days left to expiration, I would never see a three-fold increase in short put premium with a concomitant 90% decrease in the long put. For this reason it makes sense to keep them together and this should apply no matter how many legs in the spread.

I still remain leery about complex trade methodologies. These are trades with multiple legs and various [discretionary] adjustment guidelines. Target option deltas can vary as can margin requirements, PnL targets, etc. Adjustments present like a fly in the ointment. If these are actually new trades then why backtest them together as opposed to closing one trade, starting another one, and combining the results?

This is partly why I believe the appeal to complex trade methodologies including multi-legged positions with eye-popping marketing names is misguided. Large degrees of freedom significantly complicate backtesting; curve-fitting or small sample sizes muddle the interpretation. People think they are objectively backtesting while future leaks and free-range confirmation bias inconspicuously oppose them. Dream of the Holy Grail remains alive and demand to purchase the education in hopes of profitable trading is directly proportional to marketing efficiency.