Put Diagonal Backtest (Part 5)

Just to reiterate, the goal is to stay as far OTM as possible to collect all intrinsic value made available. I will collect the intrinsic value regardless of when I roll unless the market overruns, in which case I start to lose intrinsic value because rolling up will go toward capturing extrinsic until short strike is above the underlying price.

The temptation when DITM with very little extrinsic value being collected is to roll down. Watch out, though, because being overrun can cost us dearly.

The following research question remains: is it more efficient to maintain constant strike price over a series of rolls or can I do just as well if it fluctuates (lower, higher, lower, higher, etc.) within ITM range? If the former is true, then keeping strike price constant and taking the slippage hit (third-to-last paragraph here) would be more plausible. I will backtest this.

As mentioned in this second paragraph, the occasional overrun cannot be avoided. To avoid overruns at all costs, I would have to sell sufficiently DITM that TEV would rarely be attained.

That same sentence implies LIVOC can be recouped by selling additional EV later. As mentioned in Part 2 paragraph 3, amortizing this over the remaining LP life is prudent. I don’t plan to hold LP to expiration due to accelerated time decay. Taking this into consideration along with the up-and-out roll when market rallies 5-10%, perhaps amortization should be done only over the actual duration I hold the LP. This would have to be a retrospective calculation, which means any leftover deficit could be added to the subsequent LP TEV.

How bad can the overrun losses really be? Look at the risk graph below:

The upside looks pretty dangerous! The highlighted numbers on the right suggest I can lose $10,000 pretty quick, which would be a chunk of the profit accrued to date.

Looking across the top, though, reveals these to be huge changes in the underlying. I should zoom in (note percentage at bottom right) and focus over a more reasonable amount of underlying movement for the next few expirations:

Now I see that even from the peak, I would lose only ~$1,000 on a 3% upside move. This is not catastrophic loss. Let’s keep this in mind before thinking the worst, which I suggested as the “double whammy” in the fifth paragraph of Part 4.

One final backtesting note: on weeks when monthly options expire, be sure to use SPXPM because the monthly expires Friday morning and we don’t want to contend with settlement risk.