Automated Backtester Research Plan (Part 5)

Today I will finish up the automated backtester research plan for naked calls.

Once done studying daily [overlapping] trade statistics, we can repeat the naked put analysis with a serial trading strategy for naked calls. This involves one open trade at a time. We can look at number of trades, winning percentage, compound annualized growth rate (CAGR), maximum drawdown, risk-adjusted return, and profit factor. Again, equity curves will represent just one potential sequence of trades and some consideration can be given to Monte Carlo simulation. We can plot equity curves for different account allocations such as 10% to 70% of initial account value by increments of 10%.

With both overlapping (daily) and non-overlapping (serial) trades, position size should be held constant to allow for an apples-to-apples comparison of drawdowns throughout the backtesting interval. With naked puts, position size is notional risk. Naked calls, though, have unlimited notional risk. Maybe we deduct 0.05-0.20 for the naked call premium under the assumption that we always purchase the lowest strike call available for minimal price to limit margin.

This would result in a vertical spread, though, and the width would be different depending on underlying price.

Does this compromise the feasibility of naked call backtesting altogether? If calls must be done as vertical spreads then buying the long leg for minimal premium will be different from most call credit spread studies to be done for widths 10 (25) to 50 (100) points wide by increments of 10 (25)—except for very low underlying prices where the larger widths may result in the same minimally-priced long being purchased. The naked call study has then become a call credit spread study, which overlaps with the vertical spread backtesting to be detailed later. This deserves further deliberation.

We can apply the same rolling ideas to naked calls as we did to naked puts. We can roll naked calls [up and] out to the next month when a short strike is tested or when the trade is down 2-5x initial credit. We can also roll naked puts up to same original delta in the same or next month if strike gets tested.

When studying filters, it will be important to look at total number (and distribution) of trades along with equity curve slopes to determine consistency of profit. Risk-adjusted return and profit factor should also be monitored.

Naked call filters for study are similar to those for naked puts. We can look at trades taken at 5-20-day highs (lows) by increments of five. Trades can be taken only when a short-term MA is above (below) a longer-term MA. As mentioned in the Part 2 footnote, my preference would be to avoid getting overly concerned with period optimization, but this may be unavoidable. Implied volatility (IV) filters may include trades taken with IV at an X-day high (low), on the first down day for IV after being up for two consecutive days, or with IVR above 25/50.

I am curious to find out if naked calls can add to total return and/or lower standard deviation of returns.

Next time I will revisit margin considerations.