Constant Position Sizing of Spreads Revisited (Part 3)

Happy New Year, everyone!

The current blog mini-series has been a tangent from the automated backtester research plan. Today I will discuss whether fixed notional risk—with regard to naked puts and spreads—is even important.

This issue is significant because it seems like fixed notional risk is the “last man standing” since I initially mentioned it in Part 1. I have reassessed the importance of so many concepts and parameters in this research plan. The fact that they get misunderstood and reinterpreted is testament to how theoretical and highly complex they are. Especially from the perspective of avoiding confirmation bias, I believe this is all debate that must be had, and a main reason why system development is best done in groups as a means to check each other.

The reason fixed notional risk may not matter is because leverage ratio can vary. I also mentioned this in the third-to-last paragraph here. Leverage ratio is notional risk divided by portfolio margin requirement (PMR). Keeping PMR under net liquidation value and meeting the concentration criterion are essential to satisfy the brokerage. Leverage ratio can be lowered by selling the same total premium NTM. This will affect the expiration curve by decreasing margin of safety as it lifts T+x lines. Analyzing this, somehow, might be worth doing if backtesting over a delta range does not provide sufficient comparison.

Whether “homogeneous backtest” should mean constant leverage ratio throughout is another highly theoretical question that is subject to debate. Keeping allocation constant, which I aim to do in the serial, non-overlapping backtests, is one thing, but leverage can vary in the face of fixed allocation. I discussed this here in the final four paragraphs. In that example, buying the long option for cheap halves Reg T risk but dramatically increases the chance of blowing up (complete loss) since the market only needs to drop to 500 rather than zero. While the chance of a drop even to 500 is infinitesimal, theoretically it could happen and on a percent of percentage basis, the chance of that happening is much greater than a drop to zero.

Portfolio margin (PM) provides leverage because the requirement is capped at T+0 loss seen 12% down on the underlying. In the previous example, 500 represents a 50% drop. Even under PM, though, leverage ratio can vary because of what I said in second-to-last sentence of paragraph #4 (above).

When talking just about naked puts, much of this question about leverage seems to relate to how far down the expiration curve extends at a market drop of 12%, 25%, or 100%. This brings contract size back into the picture because contract size is proportional to downside slope of that curve.

With verticals, though, number of contracts is less meaningful because width of the spread is also important. The downside slope will be proportional to number of contracts. The max potential loss of the vertical depends not only on the downside slope, but for how long that slope persists because the graph only slopes down between the short and long strikes.

Either way, you can see how number of contracts gets brought back into the discussion and could, itself, be mistaken as being sufficient for “constant position size.”

I certainly was not wrong with my prediction from the second paragraph of Part 1.