Musings on Put Credit Spreads (Part 6)

3AM Eternal! My last entry was not actually posted at 03:00 and that was the April Fools joke. These days I sleep in the middle of the night unless it’s a rare weekend. Classic song, though…

In any case, I left off considering some possible ways to avoid the slippage problem.

Another possibility would be to incorporate slippage as a(n) discount (exaggeration) to profits (losses). A ballpark number I have in mind is 3%. If I sell a 10-point spread for $0.60 and close it for $0.10 then I make ~5% on it. If I discount that to 2% then I make $0.20, which is about $0.14 slippage per spread traded (leaving $1/contract for commissions).

I should expect execution to deteriorate in fast-moving markets. Since I don’t vary execution in backtesting, I should be liberal with slippage to get a realistic average. I’m not sure $0.14 per spread quite accomplishes that.

A few years ago I backtested 100-point put spreads. I intended to let the long option expire worthless, which cut slippage. The exception was when the market moved down significantly causing the long option to increase in value. With a profit-taking rule I could realize a gain before the market reverses causing the option to expire worthless. This would also prevent me from realizing a huge gain in the rare situation no reversal takes place. While a material difference exists between the two, it may be a moot point if the small sample size lacks enough consistency for future relevance.

More specifically, over the last 15 years a deep-out-of-the-money put would have gained material value roughly 11 times. These include: Sep 2001, summer 2002, June 2006, Jul 2007, Jan 2008, fall 2008, winter 2009, May 2010, summer 2011, Aug 2015, and Jan 2016. Of these 11, I’m more certain about seven (significant volatility increases). I could divide and say it happens every 16-24 months but that is an artificial construct. It happens so infrequently that I should not be surprised to go multiples of 16-24 months without experiencing it.

Inclusion of a profit-taking rule will realize more consistent profits at the cost of a few huge gainers. I cannot determine whether this is roughly equal because of the small sample size, though. This is a rare instance where 15+ years of data is probably not enough. It might amount to the difference between having a quantifiable profit-taking rule and the undefined potential of purchasing a lottery ticket.