Worst of Naked Puts for 2020 (Part 2)

Last time, I presented some manual backtesting in OptionNet Explorer selling the most inopportune monthly naked puts ~120 DTE in Feb 2020. Today I continue with more analysis, which actually takes the form of an e-mail sent to a colleague (and will therefore remain largely unchanged).

I do think this is cherry-picking the absolute worst, but you think even the absolute worst should be heeded because the market will eventually find it. Had you started a few weeks earlier or been running this campaign for several months, you would be net long puts and perhaps completely fine.

What comes next, though?

In 30 days, the market is down 950 points, which is 28%. Certainly once IV has spiked, the losses on subsequent NPs won’t be as big—but still significant. I once sold some NPs with a 3x SL. The worst in the current backtest is down 75x. That’s a wide swath for tremendous devastation: 65x, 55x, 45x, 35x, 25x, 15x, 5x, etc. Anything sold during this time is going to lose big money, which you somehow have to manage.

If you stayed out and sold no new NPs (trade guidelines needed), then when would you get back in?

And once you get back in, it’s going to take some time for those to mature and get converted to net long puts. Only then can you start placing income structures. Won’t you be starting back again at just one contract, no matter how large your account had grown and what the average annual monthly target is? Maybe it would be one tranche and the number of contracts per tranche would grow as your account grows. I’m not sure, but in any case it would be one when you’re used to having on several. What would be your guidelines to “resume” the portfolio?

On the plus side, any income structures placed in March would be in higher-IV conditions thus more resilient anyway. Might these not need a tail hedge (or would they automatically include one per the dynamic-sizer spreadsheet)? Actually, that’s a whole different structure than the tail hedge; let’s not mix multiple trading plans at once.

I can imagine a rudimentary trend-following strategy keeping you out of much of the downdraft, but I still have the same concern as explained two paragraphs above. The factory gets disrupted if you’re out for much longer than it usually takes to generate new hedges. You will eventually go from a steady state average to a lower number of hedges, which somehow means you have to decrease position size of otherwise unprotected income generators.

Maybe this is a “first-world problem” because it merely implies lower profit. The opportunity cost concern is exactly what leads some traders to size too large, though, when can later result in catastrophic loss.