Call Me Crazy (Part 1)
Posted by Mark on June 1, 2021 at 06:34 | Last modified: May 17, 2021 10:52In these two posts, I started to introduce components I am considering for a new portfolio investment approach. In this post, I will present a long call backtesting approach.
In my opinion, the long call risk graph has one very attractive potential feature: built-in insurance. I included the risk graph in Part 1 (linked above). Notice the horizontal line that extends leftward to zero. That represents a range of prices for the underlying where PnL at expiration does not change. Although I won’t discuss it any further here, this feature makes the long call a prime candidate for “cash replacement.”
When position sized properly, the long call acts like insurance because the premium I pay up front is the most I can lose until expiration. What I need to thoroughly understand is annual cost as a percentage of the underlying. The cost drags down total return, which is bad. The good thing is that I should feel completely safe in case the market goes down. Good, good, good—this is my main reason for being here today.
To gain more understanding of long calls, I conducted a backtest as follows:
- On first trading day of year, BTO the first OTM call with expiration in December two years hence.
- If underlying falls within a couple points of a strike price, then buy ATM option instead.
- Include $1.00 per contract for commission.
- Factor in [aggressive] slippage by selecting price 20% of the way between natural and mark.
- On first trading day of next year, STC the long call.
- BTO a new long call as described above.
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Data columns included:
- Date and DTE
- Underlying price strike
- Round trip commission
- Mark and actual prices for open and close
- Current cost
- Maximum ($) potential loss
- Maximum (%) potential drawdown (MPDD) for account and underlying
- Account and underlying annual ROI
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Initial metrics to compute included:
- Cumulative return
- Geometric mean
- Annualized return
- Standard deviation (SD)
- Maximum drawdown (MDD)
- Risk-adjusted return by SD, by MDD, and by MPDD
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I will present results next time.