Call Me Crazy (Part 9)

Today I finish up tying together loose ends with regard to the long call (LC) backtest.

In the bulleted list here, I suggest we might vary the DTE/DIT ratio. The current backtest holds two-year LEAPS for one year. What if I hold for 18 months? What if I buy 18 months out and hold for one year (plus one day)? Holding longer keeps the number of transactions as well as taxes down (LTCG but please consult a tax advisor as I am not a CPA and do not know your individual situation). One tradeoff is time decay, which increases as the LC gets closer to expiration.

One way to get more data points in the backtest is to buy a shorter-dated LC and hold closer to expiration. The original backtest has only 15 data points using two-year LEAPS. Alternatively, I could buy the LC one (two) month(s) to expiration and roll after three (six) weeks, for example. Many permutations are possible and what I would ideally like to see for a robust strategy is most to be profitable with superior risk-adjusted returns (especially in lieu of accelerated time decay).

Holding the LC longer when the market has declined can improve risk-adjusted return. LCs would be held for varying durations depending on underlying share performance. For a multi-year down market, this idea really seems attractive because a max loss could only be realized every two years rather than every year. Thinking about 2008-9 in the original backtest, maximum drawdown (MDD) would have been closer to 20% than the 32% seen in the enhanced data set.

When doing this “mental stress testing,” always think about the pros and cons of different tweaks. Holding the LC for longer lowers MDD in an extended downturn at the cost of slower profit after upside reversal. The unrolled LC expires worthless if the underlying fails to reclaim the strike price by expiration whereas the rolled LC profits earlier despite a larger MDD.

Also when doing “mental stress testing,” be aware that small sample sizes are very susceptible to curve fitting. We can imagine specific historical periods and forecast hypothetical performance, but when broken down into metrics (e.g. severity, duration, volatility change), each DD period is unique and small sample sizes are not to be generalized (see second-to-last paragraph here for fallacy of the well-chosen example). In the end, the best answer may be to skip the backtesting altogether and do what feels right because aborting a trading plan midstream is a good way to lose money and make us not want to look back.

Is rolling the LC up a low-probability trade and therefore something to avoid? This is effectively a bear call credit spread. Stocks have an upward bias while a call credit spread is bearish/neutral. Failure to roll would result in a more expensive LC over time. Perhaps fewer contracts could eventually be implemented to [somewhat] smooth out asset allocation.

Sticking with the same theme, rolling the LC down—effectively a bull call spread—should be a high-probability trade. This suggests we roll down when the market tanks and hold the strike as it soars. I tend to agree that when rallying, we want the LC to mimic stock. If we don’t roll, though, then we can’t get downside protection. I’m not sure how to rectify that.

The challenge with investing may not be figuring out the right or wrong strategy as much as determining the pros and cons of each and making educated choices from there.

Despite the benefits, one disadvantage to the LC is losing money if the underlying is flattish to down. This sounds like good reason to try lowering its cost basis, which is where I will head going forward.