Call Me Crazy (Part 1)

In these two posts, I started to introduce components I am considering for a new portfolio investment approach. In this post, I will present a long call backtesting approach.

In my opinion, the long call risk graph has one very attractive potential feature: built-in insurance. I included the risk graph in Part 1 (linked above). Notice the horizontal line that extends leftward to zero. That represents a range of prices for the underlying where PnL at expiration does not change. Although I won’t discuss it any further here, this feature makes the long call a prime candidate for “cash replacement.”

When position sized properly, the long call acts like insurance because the premium I pay up front is the most I can lose until expiration. What I need to thoroughly understand is annual cost as a percentage of the underlying. The cost drags down total return, which is bad. The good thing is that I should feel completely safe in case the market goes down. Good, good, good—this is my main reason for being here today.

To gain more understanding of long calls, I conducted a backtest as follows:

• On first trading day of year, BTO the first OTM call with expiration in December two years hence.
• If underlying falls within a couple points of a strike price, then buy ATM option instead.
• Include $1.00 per contract for commission.
• Factor in [aggressive] slippage by selecting price 20% of the way between natural and mark.
• On first trading day of next year, STC the long call.
• BTO a new long call as described above.

Data columns included:

• Date and DTE
• Underlying price strike
• Round trip commission
• Mark and actual prices for open and close
• Current cost
• Maximum ($) potential loss
• Maximum (%) potential drawdown (MPDD) for account and underlying
• Account and underlying annual ROI

Initial metrics to compute included:

• Cumulative return
• Geometric mean
• Annualized return
• Standard deviation (SD)
• Maximum drawdown (MDD)
• Risk-adjusted return by SD, by MDD, and by MPDD

I will present results next time.