I recently posted the rules for Theta Breakout, an Options Trend Following Trading System. The system sells out of the money naked options (or credit spreads) following a new 50 day Donchian Channel breakout. For example, a new 50 day high would trigger the system to sell out of the money puts. I’m currently in the process of a manual backtest of the system and want to share some initial results.
Initial Backtest Method:
My initial backtest was run on SPY and SPX going back two years and looking at 10 and 20 delta short options at both 60 and 90 days to expiration. Unfortunately, there isn’t much in the way of Options Backtesting software so the process is a little tedious, but it does give me a strong feel for how the system trades. Enough of the mushy gushy. The SPY results are based on selling naked out of the money options in the direction of the trend and the SPX results are based on selling a 10 Point wide vertical spread. Keep reading to find out what performed better.
Gamma & Theta on 60 vs. 90 Day Short Options:
After going back through two years of data I noticed something interesting: the profit and loss on the 60 day and 90 day options is essentially the same for the same delta. In other words, the returns for 10 delta options are essentially the same whether we sell 60 days or 90 days out. What that means is that the Gamma difference between 60 and 90 days is not significant in this system. As a result, the main reason to sell 90 day options is that we can get further from the money for the same delta and also receive more premium with the potential to hold the trade longer.
The other big take away from the similar returns at 60 and 90 days is that Theta is very linear in out of the money options that are 60-90 days to expiration. Many people like to focus on the red line in the graph that shows option prices collapsing in the last 30 days to expiration. However, the collapse in options prices takes place in at the money options. Out of the money options have a more linear rate of decay (especially further from expiration) and this backtest confirms that finding. Image credit to Charles Schwab.
The Take Away and Looking Ahead:
After going through the backtest results, it looks like selling 20 delta options results in essentially the same percentage of winning trades and has close to double the return of 10 delta options. However, the increased return also comes with larger equity swings and the losing trades are greater in both dollar and percentage terms. Selling options with 60-90 days to expiration had no impact on the initial results and the specific numbers were excluded in this post because they mirror the 60 day returns discussed.
The results above are somewhat limited in terms of the time they cover, but they give us a little insight into how the system should perform. Keep an eye on the blog this weekend for when I wrap up the full backtest that covers some additional markets (i.e. not just stocks).
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