Naked Call Backtest (Part 3)

Before proceeding with more backtesting data, I want to clarify some previous points and make a casual observation.

Position sizing based on max drawdown (DD) says “the largest DD I ever saw in backtesting was X. If I never want more than a Y% DD on my account, then minimum account size is X / (Y / 100).” As an additional margin of safety, suppose the largest future DD will exceed max DD by a factor of Z. The minimum account size becomes (X * Z) / (Y / 100).

Given the $407K MDD (one contract initial size), preference not to see my account down more than 20%, and anticipation of future max DD 2x worse than that seen in the past, minimum account size should be ($407K * 2) / (20 / 100) = $4.07M.

Even if I can position size this way based on max DD, portfolio margin requirements (PMR) could still be a limitation. As account equity decreases and margin limits approach, I may not be able to continue holding the position. Recall from Part 1 that depending on index value, PMR is $1.7M – $3.3M when starting with one contract. A $4.09M account suffering a 40% DD becomes $2.45M, which can no longer support a $3.3M PMR.

DD and position size both determine whether an account can support a position. Position size is proportional to PMR. DD affects buying power. A margin call will be issued by the brokerage as buying power approaches [and certainly slips below] PMR forcing clients to deposit additional funds or to close positions (else the brokerage will do so for them).

Vertical spreads cap PMR, which is still proportional to index price. We probably need to determine the larger of max PM or max DD (along with associated fudge factors discussed in second paragraph) and base position sizing off that.

Large variance across IV and index price level demands more dynamic guidelines for normalization. This backtest implements a static premium in the face of wide-ranging underlying price and volatility. Implementing a static delta, instead, would allow for a normalized strategy that proportionally self-adjusts over time.* If I were doing spreads, then width could be better defined [dynamically] in terms of index price since a static 200 points is 10% of 2000 and only 5% of 4000.

This can all be confusing, which is why I wrote an entire mini-series on it.

As a final note, this backtest closes all short options no later than 3:50 PM on expiration Thursday. In live trading, the short option can often be left to expire thereby saving premium and transaction fee. A cursory review of current results reveals a difference up to $15K: sizeable, to be sure, but amounting to little more than a rounding error all things considered.

*—Added to my to-do list.