Short Premium Research Dissection (Part 38)

In paragraph #2 below the first table, I said I liked our author’s exploratory backtest to assess the [MFE] distribution.

What I don’t like about this approach is a failure to explore the extremes. I mentioned this in the paragraph after the graph here. Backtesting over a range where results are directly proportional is of limited utility. Backtesting over an expanded range can illustrate floor and ceiling effects, which defines the profitable range. With regard to delta stops (profit target), I would have liked to see 0.60 (2.5%) along with 0.75 – 0.80 (10% – 15%) rather than just 0.65 and 0.70 (5% and 7.5%).

Not only is study of the extremes* useful, I can argue for it to be essential. Exploring the tails can help us understand whether we have a normal, thin-, or fat-tailed distribution. I could imagine our author giving the excuse she wanted to avoid “overwhelming” us with lots of excess data (second paragraph below table here). It’s not excessive, though, and without it we have no reason to think she actually checked it herself. Not checking would be sloppy, superficial research indeed.

In the next sub-section, our author discusses trade sizing and the commission benefits of index vs. ETF trading. Once again (as discussed near the end of Part 36), she promotes a brokerage, which signifies a clear conflict of interest. Discussing commissions but not slippage is, if you think about it, very sloppy. These are the two biggest components of transaction fees, but slippage likely dwarfs commissions. The only place slippage is even mentioned is the “hypothetical computer simulated performance” disclaimer shown here and included in all such graphs this section (+1 on consistency, for once).

The next sub-section is titled “final strategy backtests… with various allocations.” Are we now going to see what trade guidelines have made the final cut?!

No.

She proceeds by showing us “hypothetical performance growth” graphs and cursory trade statistics for a 5% profit target managed at 30 DIT or delta stops of 0.60, 0.65, or 0.70 with allocations of 5%, 10%, or 25%. She then tells us to decide based on our own individual risk (drawdown) tolerance.

For each of the three delta stops, she gives the following [incomplete] methodology:

     > Expiration: standard monthly cycle closest to 60 (no less than 50) DTE
     > Entry: day after previous trade closed
     > Sizing: 5%, 10%, 20% Allocations [emphasis mine]

This is a typographical error: 20% should be 25%. As with the first paragraph below the first excerpt of Part 36, maybe the proofreader fell asleep? Sloppiness has been a recurrent theme throughout.

     > Management: exit after 30 days, 5% profit, or at ±0.60 short delta

I will continue next time.

* Incidentally, backtesting over an expanded range would preclude the need for an exploratory
   test to determine MFE distribution.