Automated Backtester Research Plan (Part 4)

Today I continue with the research plan for naked calls.

As discussed with puts, I think naked call trades should be normalized for notional risk.

I would like to see a distribution of naked call losers in time and in magnitude. Date can be on the x-axis with underlying closing price (line graph) on the right y-axis and trade PnL (histogram) on the left y-axis. It certainly makes sense to do these graphs for expiration. We can also do these graphs for managing winners at 50% (and/or 25%?) and for managing losers.

I suggested managing trades early (i.e. exiting at 7-21 DTE by increments of seven or exiting at 20-80% initial DTE by increments of 15%) for naked puts, but I did not mention it for calls. This is because in backtesting naked calls down to 7 DTE, I am not sure what kind of time stop makes sense. Four, three, and two DTE correspond to expiration Monday, Tuesday, and Wednesday respectively—any of which would seem to be an extremely short time to hold these trades. They could be repeated every week, though. This is subject for debate.

When the market rips higher, naked calls can lose quickly because they are closer to the money. This almost makes me more reluctant to trade naked calls than puts, which is counterintuitive because traditional wisdom says naked puts are most at risk. Naked puts are vulnerable to directional moves—equity markets tend to crash down farther (and faster) than they crash up—and extremely vulnerable to volatility explosion. If volatility affects naked calls at all on strong upside moves then it generally benefits them (going from inflated IV on a pullback to normal/low IV after the rebound). The culprit hiding in the shadows is vertical skew, which makes OTM calls cheap compared to OTM puts.

This line of discussion makes me curious to know how time stops can reduce risk of naked calls despite the above discussion of why they were not mentioned in the previous post. I would be interested in seeing a histogram of PnL (y-axis) by DTE (DIT): high (low) to low (high) moving from left to right along the x-axis. This plot would be for unmanaged trades. I would expect to find that earlier exits mitigate the most extreme losses—but at what cost?

The vertical skew discussion also implies that [if implemented then] naked calls should be traded in a smaller position size than naked puts. I would like the backtest to provide some insight about reasonable position sizing. I want to study the rolling (out or up and out) adjustment and how many rolls have been historically required during the sharpest and most sustained upside moves. As an example of how this could be relevant, suppose risk management is to roll into double the position size when premium increases by 100%. If we don’t think this will happen for more than three consecutive months, then maybe position size for naked calls should be 13% (or less) that of naked puts.

I will continue next time.