Naked Call Backtest (Part 5)

As mentioned previously, increasing position size makes this profitable: not anything about the naked call strategy itself.

Do any research on Martingale betting systems and you will see they are not recommended. I wrote about this here. The smaller I start as a percentage of the total bankroll, the lower probability I will run into a string of consecutive trades long enough to go bust. Make no mistake, though: it most definitely can happen [and since Mr. Market “can remain irrational longer than you can remain solvent,” it probably will].

What are some ways a strategy like this may be viably implemented?

One way is to position size as a fraction of the entire account. I did calculations in Part 4 based on $240K risk. If this is 10% (for example) of my total account, then I can rest easy because at absolute, never-before-seen worst, I lose 10%.

Another way to trade this responsibly might be to overlay on top of a long strategy that offsets naked call (or vertical spread) losses when the market rallies. Keep in mind that calls are NTM compared to equal-delta puts due to vertical skew, which means portfolio margin requirements can grow faster. Trading fewer call than put contracts as net short premium is one way this can make sense; just remember the number of call contracts may increase at least 16-fold.

Implementation of stop-losses is another avenue for the naked call (or vertical spread) strategy. By improving the avg win:avg loss ratio, I can mitigate position size increases. Stops increase number of losses, though, because a trade cannot recover once it has been closed. Backtesting is needed to better understand whether one factor is clearly more likely to prevail.

Finally, intraday backtesting (discussed in this blog mini-series) remains undiscovered country. Mine is a once-daily backtest,* which allows up to 24 hours for things to go from bad to worse. The worst backtesting loss is on 4/6/20 when a call sold for $1.35 is closed for $45.30. As mentioned in the second-to-last paragraph here, I think ITM short puts are best rolled before they go OTM. The mirror image dictates rolling short calls before they go ITM. Win percentage would decrease, but magnitude of loss would be lower. Again, backtesting is needed to better understand whether one factor is clearly more likely to prevail.

As discussed in the last paragraph here, by rolling rather than taking on some unknown legging risk and leaving short options to expire worthless, the current backtest errs on the side of conservatism. Rolling involves buying out remaining premium and realizing excessive slippage upon exit, which would both be expected to dampen performance slightly.

* — I used market prices at 3:50 PM until Dec 2020 and at 3:45 PM daily thereafter.
       This was due only to inadvertent oversight. The catch-22 is to use data as
       close to expiration (4:15 PM ET) while not suffering widened, distorted bid/ask
       spreads often seen after normal market close (discussed in fifth paragraph here).