Constant Position Sizing of Spreads Revisited (Part 1)

In Part 7, I said constant position size is easy to do with vertical spreads by maintaining a fixed spread width. I now question whether a fixed spread width is sufficient to achieve my goal of a homogeneous backtest throughout.

I enter this deliberation with reason to believe it will be a real mess. I have addressed this point before without a successful resolution. This post provides additional background.

The most recent episode of my thinking on the matter began with the next part of the research plan on butterflies. I want to backtest ATM structures and perhaps one strike OTM/ITM, two strikes OTM/ITM, etc. Rather than number of strikes, which would not be consistent by percentage of underlying price, a better approach may be to specify % OTM/ITM.

I then started thinking about my previous backtesting along with reports of backtests from others suggesting spread width to be inversely proportional to ROI (%). It makes sense to think the wider the spread, the more moderate the losses because it’s more likely for a 30-point (for example) spread to go ITM than it is a 50-point spread with the underlying having to move an additional 20 points in the latter case. This begs the question about whether an optimal spread width exists because while wider spreads will incur fewer max losses, wider spreads also carry proportionally higher margin requirements.

Also realize that a 30-point spread at a low underlying value is relatively wide compared to a 30-point spread at a high underlying price. I mentioned graphing this spread-width-to-underlying-price (SWUP) percentage in Part 7. We could look to maintain a constant SWUP percentage if granularity is sufficient; with the 10- and 25-point strikes most liquid, having to round to the nearest liquid strike could force SWUP percentage to vary significantly (especially at lower underlying prices).

All of this is to suggest that spread width should be left to fluctuate with underlying price, which contradicts what I said about fixed spread width and constant capital. We can attempt to normalize total capital by varying the number of contracts as discussed earlier with regard to naked puts. From the archives, similar considerations about normalizing capital and granularity were discussed here and here.

Aside from notional value, I think the other essential factor to hold constant for a homogeneous backtest is moneyness. As mentioned above, spreads should probably not be sold X strikes OTM/ITM. We should look to sell spreads at fixed delta values (e.g. “short strike nearest to Y delta”) since delta takes into account days to expiration, implied volatility, and underlying price.

An interesting empirical question is how well “long strike nearest to Z delta” does to maintain a constant SWUP percentage.