Call Me Crazy (Part 4)

I’ve been digging into results from my backtest on the long call versus underlying stock shares. Last time I took a deep dive into the numbers behind RAR by MDD. Today I want to move forward.

MDD is based on a single occurrence, which is one thing I do not love about the risk metric. As discussed here, large sample sizes lower the possibility of fluke occurrence. This is difficult when starting with a set consisting of only one data point per year even enhancing with 24 points of additional context. Alternatives to MDD include top three DD’s (referenced in the fifth paragraph here), average of the top three DD’s, or distribution of DD’s.

RAR by standard deviation (SD) sidesteps the single-occurrence issue by looking at overall variability. For the enhanced data set, this is 9.53 for the long call vs. 5.57 for SPX shares. This is a 1.7-fold difference compared to 1.1x (7.48 versus 6.70) in favor of the long call in the original data set. This feels right* because the enhanced data set includes additional downside volatility and was precisely the motivation for my last post.

Looking at the equity graphs in Part 3, the enhanced data set exhibits additional curve crosses. March 2020 is the real eye-opener because a substantial lead accumulated by the SPX account for over a decade evaporates in one fell swoop before completely recovering within six months. What a ride, though: adrenaline junkies rejoice! This is the opposite of what seniors or anyone with retirement in their sights want to see.

SPX hits an all-time closing high (ATH) of 1565.15 on Oct 9, 2007. I’m tempted to include this in the enhanced data set to see how it would affect the numbers. ATH is a 10.49% increase from Jan 2007 where the long call is up 8.78%. I’m guessing inclusion would mitigate the difference between original and enhanced data sets for RAR by MDD, accentuate the difference for RAR by SD, and add a couple more crosses to the equity graph.

Whether the ATH should be included is debatable. I aim to understate backtesting differences to strengthen my beyond-a-reasonable-doubt (see last paragraph here) search for viable strategies going forward. The main reason not to include is that upside volatility will not result in loss. Main reasons to include are because upside volatility is very real and because upside volatility can result in psychological loss if DD’s are calculated from a highwater mark (potential topic for future blog post).

I will continue next time.

* — What doesn’t feel so right is the impressive result that long call SD decreases from 0.141 to 0.112
       between original and enhanced data sets where SPX-share SD increases from 0.160 to 0.191.