Fixed Credit vs. Fixed Delta

The issue of fixed credit vs. fixed delta has come up a couple times recently including the previous blog series.

I used fixed credit when backtesting naked puts. Fixing credit rather than delta means short delta decreases as the underlying price goes higher. This boosts probability of profit (PP).

Fixed credit may be apples-to-oranges because an increased PP over time means fewer losses. This will likely result in more linearity to the equity curve as underlying price increases. In other words, as time goes on the system may work better for no reason attributable to the strategy itself. Compared to fixed delta, I am effectively trading smaller and more conservatively with the end result serving to retain profits I already have.

Because of the similar feel, I wonder if this is another form of apples-to-oranges comparison: variable position sizing. This would be a definite no-no in trading system development. Number of contracts remains constant throughout. Max loss per contract remains constant throughout. Only when I looked at capital risk did I see the variability. I would be interested to analyze capital risk over time with fixed delta to compare.

While fixed credit may seem like apples-to-oranges, the pursuit still seems defensible to me. Without question, I want that linear equity curve. If fixing credit generates a linear equity curve then have I cheated by allowing the probabilities to increase over time? Intuitively, I feel a higher PP and concomitant lower credit may mean larger net losses when the market suffers significant corrections. This disadvantage to fixed credit should even the score.

Whether the magnitude (%) of corrections is correlated to underlying price is a different study altogether. I could probably attempt to analyze this but I have a very small number of market corrections to sample. Since the financial crisis, we had the Flash Crash (2010) and the Fiscal Cliff (2011), but then nothing until fall 2014 and the two recent 10% corrections of Sep 2015 and Jan 2016.

In summary, I like what I see with fixed credit but remain uncertain about its validity. While it seems semantically valid (“remains constant throughout“), the effect of the fixed numbers is analogous to variable position sizing and that is what troubles me. Completing the fixed delta backtesting must be done to answer some of these questions.