Put Diagonal Backtest (Part 4)

Today I continue with discussion and analysis of my first ever put diagonal backtest.

I left off saying once my short option goes OTM, the only way I can recoup the loss is if the market subsequently crosses below my strike. Once I roll when OTM, intrinsic value is lost…

…for good?

Suppose I roll out to the same strike, market reverses lower, and the option is again ITM at expiration. The LIVOC has now been restored. This is a gamble because equities historically display positive drift by rising more than 50% of the time. The risk is that a small amount of LIVOC becomes a huge amount of LIVOC if the market continues to rally.

Rolling straight out on Mar 23, 2020, for example, could be devastating. This is one of many up days at the start of a huge uptrend covering hundreds of points. Compounding positional losses with the reality of losing big while everyone else is gaining/winning amounts to a double whammy from which psychological recovery could prove extremely difficult. This is directly related to the subject of emotional investing.

If the market seems to be in a downtrend, then I can gamble by rolling OTM rather than ITM. If correct, then I avoid losses that would otherwise result from increased intrinsic value down to the strike price: when intrinsic value starts to build. Again, I call this gambling for the same reason given two paragraphs above.

The struggle is real between rolling to a lower strike and rolling to the same DITM strike for no extrinsic value and potential loss due to slippage. As the market falls and I remain on the fringe of TEV or less, I am tempted to roll down to be more within the meat of the T. Prem distribution (displayed in the second table of Part 3). This would raise more than TEV and prevent me from facing this dilemma repeatedly over subsequent expirations.

In the backtest, I sometimes rolled out 2-3 weekly expirations (4-7 additional days) to capture what seemed like a reasonable average EV. As an example, sometimes rolling out 3 DTE—Friday to Monday—would generate zero EV but 5 DTE—Friday to Wednesday—could be done for $2.20 EV, which is an average of $1.10 over two cycles. If my TEV were $1.00, then I would take that! I hate to lose money due to slippage alone, which argues for rolling down and collecting enough EV to offset.

I would still have to roll higher for the subsequent expiration after a big up day, though, and this represents LIVOC risk.

I will continue next time.