Backtesting Duration in Credit Spreads
Jun 6, 2017
While a trader's unique approach and strategy will likely dictate their tastytrade programming preferences, a recent episode of Market Measures is "must-see TV" for any traders who routinely sell premium.
As we've highlighted recently on the blog, a key to trading is isolating your own risk profile, and then striving to deploy positions that adhere to it.
For traders seeking to avoid potentially unlimited losses, defined risk trades offer known maximum gains and losses. One such position is the vertical spread.
A "vertical" is a spread that involves simultaneously buying and selling options with the same expiration but different strike prices. Additionally, they are executed with calls or puts (not both), in a 1:1 ratio, and with one strike closer to ATM than the other.
The easiest way to think about the risk profile of a vertical spread is to think of the position as being dominated by the ATM strike, and capped by the OTM strike (often called the "wing").
So for example, if you sell an ATM put in AAPL, you have unlimited risk. However, in a vertical spread you also purchase an OTM AAPL put not far below it, which caps your maximum loss.
Getting back to Market Measures, the primary focus of this episode is credit vertical spreads. "Credit" refers to the fact that money has been collected for executing the spread, because the option with the higher premium was sold, and the option with the lower premium was bought.
A "debit" spread indicates the opposite, that money was paid out of a trader's account in order to execute a spread.
A credit vertical spread, therefore, indicates that the trader has sold an ATM call or put, and simultaneously bought an OTM call or put against it.
Now let's consider the risk profile of a credit vertical call spread, and a credit vertical put spread.
In the case of the call spread, selling the ATM option versus buying an OTM option in equal parts means a trader has net short delta through the spread - which means credit vertical spreads have a slightly bearish directional bias.
On the put side, selling an ATM put versus buying an OTM put (in equal ratio) means that a trader has net long delta, which means a credit vertical put spread is slightly bullish in nature.
It should be noted that depending on a trader's strategy and approach, he/she may decide to “hedge away” the delta bias of the spread by trading the underlying stock against it. We'll be following up on this in greater detail in a coming blog post.
In this episode of Market Measures, the team explores the historical performance of credit vertical call and put spreads in hopes of gaining more context on the ideal duration of such positions.
In essence, the study's purpose is to evaluate the returns on credit vertical spreads of different duration to see if a pattern emerged regarding relative performance.
The study was conducted using the following parameters:
Leveraged SPY data from 2005 to present
Sold the 30 delta/10 delta credit put spread and 30 delta/10 delta credit call spread
Backtested 3 categories of duration, 15 days-to-expiration, 45 days-to-expiration, and 75 days-to-expiration
Managed at 50% of initial credit when possible
The results of the above backtest are important enough that we recommend viewing the entire episode of Market Measures to ensure the most comprehensive understanding of this material.
Specific takeaways of this research are highly dependent on each trader’s unique risk profile and trading approach.
Generally speaking, the backtest did show that the win rate of the three credit put spread duration categories (15, 45, and 75) were all 88% or higher. However, the average P/L increased significantly as duration increased, with 75 days-to-expiration being the highest of the three.
The average P/L of the three credit call spread categories was relatively less impressive as compared to the credit put spreads. In this case, the 45 days-to-expiration category produced the highest average P/L.
It should be noted that the market’s positive drift (on average, over time) likely contributes to the improved performance of the credit put spreads, which have a bullish delta bias.
We hope you’ll reach out with any questions about credit call and put spreads at your convenience. You can reach us 24/7 at firstname.lastname@example.org.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.