A comparison chart of selling naked puts and spreads

I have been studying ways to sell options using a modified super trader Karen style for non-PM (portfolio margin) accounts (including IRA). To reduce risks, we have to sell spreads instead of naked options. Thus, it's very interesting for me to understand the differences of selling spreads or naked options. Today, I finally got some time to analyze the differences from the P&L behavior perspective. Other aspects (ROM, Bid/Ask slippages under high volatilities, easiness of execution, commissions, etc) of the differences will be studied later.

I selected a recent period that involved some market fluctuations as shown in the picture below. A 20% ITM probability put on SPY (2014May$175p) was used as the basis. The profit and loss of the following 3 option selling strategies were charted by a ThinkScript that I developed:

• Short Naked put
• Short put spread of $7 wide
• Short put spread of $3 wide

As the width of the spread got narrower, the overall contract sizes were increased to maintain a similar level of maximum potential profit. The overall Delta of each strategical position was kept to a similar value around 200. As can be seen in the chart, all of the positions behaved similarly for these trades. They reached 50% profit target in a couple of weeks before dropping to negative territory, then bouncing back.

Due to the different contract sizes, the overall Greeks of the option positions were in similar ranges. Therefore, it's understandable that the P&L of these positions behaved similarly. If the number of contracts were kept the same for each position, then the spreads would have smaller Greeks values than those of the naked puts. In this case, I would expect the P&L curve of the spreads become less volatile than the naked put position, and it takes longer time for spreads to reach profit target. The narrower the spread, the slower its P&L moves. Additionally, the study focused on the 2nd month before expiration. If we chose a period that was closer to the expiration, I would expect larger behavior differences due to increased Gamma risk of the positions.

Issues in the TOS ThinkScript

I found there were many missing data points for extremely far OTM options, even though the ThinkBack showed valid data. I tried to analyze a put spread $159/$149 which had a 5% ITM probability for the short strike. But the corresponding P&L curve appeared to be erratic. After some investigation of the script, I realized that for far OTM options which traded less often (OI < 1,500) there were too many data holes to receive a proper chart. For this reason, I had to increase the ITM probability of the strikes used for this study. I plan to share the script with the Karen Study Group later.

Selling calls of small Delta in up-trending market

In analyzing my losing bear call spreads in the last couple of months, I updated my TOS option profit and loss charting script so that it can track daily P&L for 6 rounds of trades. Then I did a back-test to see if I could keep selling calls with increased size and fixed Delta around 0.32 to end up with profitable month in current low volatility environment (VIX around 13 to 17).

As shown in the picture above, I made the trades using a combination of technical analysis and high probability method. On the technical side, I thought SPY broke a major support level of $177.5 initially and faced a resistance level of $185 later. All of these were invalidated by market moves. On the high probability side, I used Delta around 0.3 for short call options which corresponded to 70% probability of success approximately. After one adjustment, I decided to close all positions on 2-28 for a loss.

In my back test today using the ThinkScript, I wanted to see if I could adjust losing trades by increasing position size while keep Delta around 0.3 for up trending  market since I believe market does not "crash-up". So I started the bear call spread at 1 contract on 2-5. In the 1st adjustment on 2-12, I increased the contract size to 2. In the 2nd adjustment on 2-28, I increased the contract size to 3. When looking for Delta around 0.3, I found the strike prices got a lot more closer to the current SPY price as we approached expiration day. With 28 DTE, the short call price could be just $2.00 above current SPY price.

Thus, this test leads me to believe that we would still face challenges if we continue selling of small Delta (or small ITM probability) call options of the same month as the adjustment strategy in our efforts to maintain profitability for the option cycle in high probability trades even if the contract sizes are increased to bring in more potential profits to offset trade loses of adjusted trades. The starting point of the trade is also very important. If the trade did not start at the bottom of the Bollinger Band, the adjustment should work much better.

Due to the lack of any option data on 2-28 and in that weekend in TOS software (both ThinkBack and ThinkOnDemand), I could not sell option on that day while SPY price was higher in this back test.

Some thoughts on back testing Super trader Karen's portfolio entries

In the last couple of weeks, our study group started some back-tests on Super-trader Karen's strategy. I worked on the entry rules as a beginning. Although major rules are described in my original post, there are some details or flexibility that need further explorations regarding the opening of the monthly portfolio.

Since all positions are not opened on day 56 to expiration, we need to have a range of opening days first. Then we should have some rules on when (conditions) to open options within the opening day ranges. Next we will need to figure out how many more puts to sell if necessary.

Personally, I prefer to test the opening of positions around 56 DTE +/- 7 days, because some of my recent studies showed far OTM option decay with a good rate starting around 2 to 2.5 month to expiration.

So, what are possible conditions for entering new trades in these 2 weeks? I tested the following rule briefly today, using an up-trending period from late October to November last year.

o   Before half positions are entered around 56 days to expiration (56 DTE + 7 days)

§  Sell put if market drops for 1 day and sell call if market rises for 1 day

o   After half positions are entered around 56 days to expiration (56 DTE - 7 days)

§  Sell put if market drops for 1 day and sell call if market rises for 3 days

DTE	Date	Option	Strike	Price	SumPremium
58	10/23/2013	S Put	151	0.265
57	10/24/2013	S Call	184	0.4	0.665
52	10/29/2013	S Call	186	0.35	1.015
51	10/30/2013	S Put	154	0.245	1.26

The December expiration monthly portfolio P&L chart is shown below. In the rising market, the short call strike at $184 got approached but not violated near the end of the option expiration. The 50% profit target worked well for this month as shown by the green bubble. The yellow bubbles named C1Back, P1Back and C2Back were located approximately 1 month after their corresponding entries.

In this example, holding positions longer than 30 days caused maximum profits for the portfolio. It was a surprise that this cycle would end in profits as the original thoughts were trying to find a tough period for the back test in the up-trending days (I'll provide an update if my script is found to have a bug). Due to the multiple entry dates and the fact that SPY never ended above the lowest upper short strike, the P&L of this cycle was not challenged at all.

Portfolio entry tests are a beginning of the back tests. We need to test various entry rules on different types of market conditions. After that, the adjustment rules will need to be back-tested. This may be the most complicated part of the strategy. Later on, exit rules will need some tests as well. Finally, we will put the rules together for comprehensive back-tests and finalize all the rules of the strategy.

The back-tests use end of day data only, as explained in the prior post. We will have to perform and analyze some paper trading which will give us real time trading experiences for this strategy before going on live accounts in the future.

Framework for Backtesting Super Trader Karen's strategy

During the holiday season, our super trader study group made some progresses. We started using TOS software to back test Karen's strategy. It will take quite some time for us to complete it. Here're some of my initial thoughts that I can share.

The ThinkOrSwim software provides two features that can be used for back testing: ThinkOnDemand and ThinkBack. The TOD supposedly offer a market DVR that records all market data at intraday as stated by the vendor's announcements. In reality, we found it not suitable for any option strategies that use high probabilities. These type of strategies require usages of far out of money strikes which are missing in TOD. TOD offers most option Greeks up to 10 strikes. Delta for far OTM options can be retrieved in TOD, but other important Greaks and ITM probability numbers are not available. The implied volatility of far OTM options are also available, but not consistent with actual IV in trading window as pointed out in a previous post. Additionally, the important market crash data happened in 2008 are not available in TOD.

The ThinkBack (TB) feature supports end-of-day data for a lot more option strikes, including the Greeks and ITM probabilities. So we have to use the ThinkBack feature in our back tests in order to find the option's ITM probability, etc. NOTE: The Greeks presented in ThinkBack were reported to have some discrepancies in my post before.

Going through TB manually for any serious back tests are not practical, as it requires users to click on each date. The ThinkScript (TS) becomes handy to help the back tests when used together with the TB. The TS can be developed to show all entry, exit, adjustment points on a chart, along with other important trading portfolio information. However, there are also limitations by TS: the ITM probability is not accessible and option Greeks can not be cross- referenced in a portfolio that includes multiple options.

Back-testing under the above mentioned constraints is challenging. But I believe it will still provide some insights about the strategy. I have created a step-by-step guide for how to use ThinkBack and ThinkScript to perform back tests on the super trader's strategy in a document. Using an initial version of our script, it gives a couple of charts that illustrate a simple strangle trade and a short call trade.