Automated Backtester Research Plan (Part 7)

Once done with straddles and strangles, put credit spreads (PCS) are next in the automated backtester research plan.

The methodology is much the same for PCS as for naked puts, which I detailed here and here.

We can first study PCS placed every trading day to maximize sample size. Trades can be entered between 30-64 days to expiration (DTE). The short leg can be placed at the first strike under -0.10 to -0.50 delta by increments of -0.10. We can hold to expiration, manage winners at 25% (ATM options only?) or 50%, or exit at 7-21 DTE by increments of seven. We can also exit at 20-80% of the original DTE by increments of 15%. We can manage losers at 2x, 3x, 4x, and 5x initial credit. I’d like to track and plot maximum adverse (favorable) excursion (no management) for the winners (losers) along with final PnL and total number of trades. I want to monitor winning percentage, average win, average loss, largest loss, profit factor, average trade (average PnL), PnL per day, standard deviation of winning trades, standard deviation of losing trades, average days in trade (DIT), average DIT for winning trades, and average DIT for losing trades.

As always, I think maintenance of a constant position size is important. This is easier to do with vertical spreads because the width of the spread—to be held constant for each backtest—defines the risk. We can vary the width between 10-50 points by increments of 10 or 25-100 points by increments of 25 depending on underlying.

My gut says that we do not want long legs acting as unreactive units (standard options) at lower (higher) prices of the underlying. Rather than an apples-to-apples backtest throughout, this would actually be two different backtests with the long leg serving only as margin control at lower underlying prices and as an actual hedge otherwise. Unreactive units may result when the spread width is too large as a percentage of the underlying price: this percentage should be graphed over time. An alternative way of analyzing this is hedge ratio, which can also be graphed over time. Hedge ratio equals decay rate (theta divided by mark) of the short option divided by decay rate of the long. A hedge ratio less than 0.80 is suggestive of long option decay that is too rapid for the short. This may leave the short option unprotected.

The importance of this last paragraph is subject to debate. I alluded to the subject earlier where I cursorily addressed the feasibility of naked call backtesting altogether.

Shorter dated trades, which have not been discussed thus far in the research plan, may also be studied. I would be interested in studying trades placed at 4-30 DTE with all the permutations given above. We can also use weekly options [when available] subject to a liquidity filter. This filter can check for a minimum open interest requirement or a bid-ask spread below a specified percentage of the mark.

General filters can also be studied as discussed in Part 2 (linked in paragraph #2 above).

I will continue next time.