Musings on Put Credit Spreads (Part 7)

That last sentence strikes me as quite profound.

For the sake of backtesting, given these two choices I should go with the one offering a decent sample size. Discretionary traders make a [temporary?] living trading based on small sample size. Trading system salespeople use small-sample-size examples as presentation material (e.g. fallacy of the well-chosen example). I want to limit the chance of something unexpected happening, though, and a small sample size puts me at risk.

From a marketing standpoint it can’t hurt to be net long puts. I cannot reliably backtest efficacy because the number of cases where they would have saved my bacon is so few. Especially because I have to believe “my worst drawdown is always ahead,” though, long puts are insurance against something horrific. I feel confident in saying that while the broad market has never gone to zero, if people are exposed to huge risk should that happen then they would be reluctant to invest. On the flip side, while the broad market has never gone to zero, if being net long puts would result in windfall profits should that happen then people would feel quite secure about investing.

It couldn’t hurt to have both, either. Maybe I should choose a conservative profit-taking target and also buy an extra long option to serve as catastrophic insurance.

Getting back to the matter of the spread backtesting itself, my deliberation led me to believe going wider on the spread might be necessary to overcome slippage. The greater credit received would somewhat offset slippage but result in a lower ROI and it wouldn’t help in a market crash where slippage would be gigantic either way. It’s a bit sad if I have to widen the spread simply for the sake of backesting but I may have to since I don’t know how spreads have traded in real time.

I could aim for a fixed credit but that might result in variable short deltas and probability of profit. As the underlying increases in price, a fixed option premium is available farther OTM. I am assuming this would pertain to spreads too although with the long option offset, I really don’t know for certain until I look at some historic data.