A Simple Framework to Quantify your trading - Part.3 of 3 (Layering on OPTION TRADES)
A Simple Framework to Quantify your trading - Part.3 of 3 (Layering on option trades)
To finish off our series, now that we have a basic mechanical system to identify entries and exits on a basket of stocks/etfs, as option traders the real fun begins.
The best thing with options is that it lets you control your risk in a manner not possible otherwise - not just binary long-short. That is both a blessing and a curse, more blessing I would argue - a curse because to provide this non-binary option you are exposing yourself to more variables than that are present in a binary world aka., time, volatility, even liquidity to a certain extent. .
So lets look at how we could layer these option trades based on our entries an exits.
Start with a good understanding of the system itself - average days in trade; average pnl per trade, max and min pnl etc., and how volatile the results will be. In the system posted in the previous parts, the average pnl on the long side is 59 cents per trade and average hold is 6-7 trading days.
With that knowledge, you can easily layer a few types of options trades that will work ok with the system (why not pick one instead - there is a reason; more about that later in the post):
1. Long Call
2. Long call vertical/short put vertical
3. Fly or an IC with bias towards the upside.
How will they look like:
Long Call vertical: (note I picked a 4 lot to make it comparable to the long call cost I picked as the next example)
Long Call:
An IC to the upside (Pick a fly if you want; same deal):
Note the IC has a negative delta even though the tent is to the upside, so it will behave very differently than all the other variations we picked. Hence I did not want to pick one trade - but the point is you should be looking at various structures and understand and backtest each of these and compare against each other.
Also lets throw in an unbalanced IC, with less risk to the upside since we are wanting to lean long:
Note a few things in the above examples,
1. I have made every trade to have a max risk of about 1200 bucks - to match the max risk of the naked call, so they are comparable.
2. Most have their tent or profit zone to the upside - but all are different. The naked call will loose money even if the move to the upside happens but does not happen fast enough or if vol works against you more than expected.
3. The tents in the IC examples, give a nice zone of profit biased to the upside, but too much move in the right direction can still hurt your trade even though you were bent in the right direction.
Now with these 4 or 5 different options, you have the DTE to pick from. I have picked a 20DTE option in this case; its about a bit more than twice than our mechanical systems average days in trade. Idea being it gives you a bit more rope wrt time. Can you go even longer duration or even shorter - absolutely and none of those is right or wrong. Just two more parameters that you might need to test to get a feeling for how a live trade would go.
So with these options if I were setting up for a backtest, I would be going with a table something like
With these comparisons, you might want to add a few more variations:
1. DTE variations (10DTE, vs 20DTE vs 40DTE)
2. Exit variations (System exit vs At-Expiry vs say at 50% Profit Exit)
Once backtested, you want to now look at average pnl for each of the systems (which will be very different from each other), standard deviations, max and min pnl (kind of observed in standard deviations anyways), probably compute a sharpe or sortino ratio of the results to give a simple one numeric to compare each of the systems against.
And bingo; now you have your own system that you know inside out - and no more dependence on purchasing blackbox entries with zero proof of working even in the past (forget the future).
The future will surely be different than the past (maybe), but you will know why when a system fails or needs a tweak - how to approach about it.
As a final word, yes its a lot of work - even though we started to come up with a simple framework, but this is the worlds finance playground and everyone is out there to eat the others lunch out. So don't expect things to come easy - simple but not easy.
Once its all said and done, you now want to start small and put real trades with real money - and be ready to learn the next set of things. Execution will surely teach your a thing or two (if not a dozen or so lessons) to keep you busy and interested for years to come. Welcome to the interesting world of trading. This is just a start.