Deleveraging Put Verticals (Part 2)

Today I continue by discussing risk reduction of the put vertical strategy.

The primary factor that determines position sizing is probability of profit. Assuming I allocate full capital, this indicates how likely I am to survive until tomorrow. The lower my probability of profit, the smaller I will trade. I also want to understand average-loss-to-average-win ratio. If one loss wipes out many wins and I don’t have a sufficiently large probability of profit then I may not believe I could ever recover from a loss. This would be a strategy to avoid. I have talked about catastrophic loss and drawdown especially as it pertains to position sizing extensively in this blog.

The sample trade given has an annualized ROI of ~122%* but also hits max loss if the market falls >3.2% at expiration, which is not a rare occurrence. I do not need to profit at an annualized rate of 122%, though, to meet my profit goals.

One thing I could do is deleverage the trade by holding some multiple of the margin on the sidelines. The sample trade has a margin requirement of $64.05. If I allocate $64.05 * 4 = $256.20 instead then my annualized ROI falls to 122% / 4 = 30.5%. Not only is this sufficient for me, it allows for a positive size increase up to fourfold. If the market falls 3% then maybe I double the size and roll down. If the market continues to move against me then I could repeat. Backtesting can give an historical winning percentage for this trade, which can help me with initial position sizing.

Unfortunately, deleveraging does not result in a proportional increase in downside protection. I thought allocating 4x initial margin to the trade was effectively increasing my downside protection to 12.60% (3.15% * 4), which would be far less likely to occur in 10 days. As expiration approaches OTM options decay exponentially faster, which may impede my ability to roll down for enough credit to recoup losses even with a doubling/quadrupling of position size.

If the market moves against me then another possibility would be to roll the trade out in time. This would soften the blow from rapid option decay. I need to be careful, though, because in addition to lowering annualized ROI by deleveraging I would now be further lowering annualized ROI by lengthening trade duration. This decreases number of potential trades per year. Avoiding a loss is arguably the best thing I can do to save performance but I also want to monitor realistic probability the ROI will meet my income needs.

* Annualized indicates attainable by continuously having an open trade and winning every time, which is fictional at best.