In this post we’ll take a look at the backtest results of opening one RUT short put 7 DTE through 365 DTE (LEAPS) position each trading day from Jan 3 2007 through Sep 27 2022 and see if there are any discernible trends.
We will also explore the performance of the s4 signal. The s4 signal is a boolean (TRUE / FALSE) daily indicator that attempts to identify the days in which short put and short vertical put positions on the Russell 2000 are most likely to be profitable at expiration. s4 is based on data from Cboe and S&P Global.
- Weekly (7 DTE) options were introduced on:
- IWM circa May 2010
- RUT circa Mar 2011
- The 7 DTE strat will use IWM as the underlying as there is more historical data available
- The start date will be Jun 3 2010
- Greater historical data of IWM was prioritized over greater commission efficiency of RUT options
- Methodology on commission addresses differences in trading fees
- Tables will have two “buy and hold” values for the IWM total-return benchmark: one that aligns with the start/end dates of the 7 DTE strat and one that aligns with all the other strats
- if we open and hold-till-expiration a short put position on the Russell 2000 on the days in which s4 is TRUE, and take no action on the days in which s4 is FALSE, we will outperform a strategy that opens and holds-till-expiration every trading day with regard to total return, risk-adjusted return, and max drawdown
- if we open and hold-till-expiration a short put position on the Russell 2000 on the days in which s4 is FALSE, and take no action on the days in which s4 is TRUE, we will underperform a strategy that opens and holds-till-expiration every trading day with regard to total return, risk-adjusted return, and max drawdown
- the s4 signal, when levered, can outperform a 100% allocation (eg: no leverage) to buy-and-hold IWM total return portfolio with regard to total return, risk-adjusted return, and max drawdown
To test these theses we will:
- limit order entry to only the days in which s4 = TRUE to see if the strategy outperforms daily entry in a statistically significant way
- limit order entry to only the days in which s4 = FALSE to see if the strategy underperforms daily entry in a statistically significant way
- compare performance of s4 = TRUE and s4 = FALSE strats against an IWM buy/hold portfolio at 100% allocation, no leverage, with dividends reinvested (total return)
Performance of the s4 signal is explored in different contexts in other, non-paywalled s4 signal studies.
There are 15 backtests in this study evaluating over 36,400 RUT short put 7-365 DTE (LEAPS) s4 leveraged trades.
Let’s dive in!
The s4 signal yielded up to a 147% / 2.5x improvement in capital efficiency over “market-agnostic” daily short put strats.
The s4 signal outperformed a “buy and hold” strategy with regard to:
- total return (5 out of 5 strats)
- risk-adjusted return (5 out of 5 strats)
- annualized volatility (4 out of 5 strats)
- max drawdown (3 out of 5 strats)
- max drawdown duration (5 out of 5 strats)
The s4 signal outperformed a “market agnostic” daily short put strategy with regard to:
- total return (3 out of 5 strats)
- risk-adjusted return (4 out of 5 strats)
- annualized volatility (4 out of strats)
- max drawdown (4 out 5 strats)
- max drawdown duration (5 out of 5 strats)
- win rate (5 out of 5 strats)
- premium capture (5 out of 5 strats)
- profit spent on commission (5 out of 5 strats)
- Symbol: RUT
- Strategy: Short Put
- Days Till Expiration:
- 7 DTE +/- 4, closest to 7
- 45 DTE +/- 17, closest to 45
- 90 DTE +/- 30, closest to 90
- 180 DTE +/- 45, closest to 180
- 365 DTE +/- 180, closest to 365
- Start Date: 2007-01-03
- End Date: 2022-09-27
- Positions opened per trade: 1
- Entry Days: each trading day in which s4 signal = TRUE
- Entry Signal: s4 signal
- Timing 3:46pm ET
- Strike Selection
- 50 delta +/- 8, closest to 50
- Trade Entry
- 50D short put
- Trade Exit
- Hold till expiration
- Max Margin Utilization Target (short option strats only): 100% | 5x leverage
- Max Drawdown Target: 99% | account value shall not go negative
- Margin requirement for short CALL and PUT positions is 20% of notional
- Margin requirement for short STRADDLE and STRANGLE positions is 20% of the larger strike
- Margin requirement for short VERTICAL SPREAD positions is the difference between the strikes
- Margin requirement for short CALENDAR SPREAD positions is 20% of the short option (short option expires after the long option)
- Margin requirement for long CALENDAR SPREAD positions is the net cost of the spread (short option expires before the long option)
- Early assignment never occurs
- There is ample liquidity at all times
- Margin calls never occur (starting capital is arbitrarily set so that max margin utilization never exceeds 100%)
- Apply a 20% discount on displayed results. For example, if a strat depicts a CAGR of 10%, assume that it’ll yield 8% in practice. This is to account for hindsight bias being used when determining starting capital in the backtest.
- Prices are in USD
- Prices are nominal (not adjusted for inflation)
- All statistics are pre-tax, where applicable
- Margin collateral is invested in 3mo US treasuries and earns interest daily
- Assignment P/L is calculated by closing the ITM position at 3:46pm ET the day of position exit if managed early or 4:00pm if held till expiration
- Commission to open, close early, or expire ITM is 1.00 USD per non-index underlying (eg: SPY, AAPL, etc.) contract
- Commission to open, close early, or expire ITM is 1.32 USD per index underlying (eg: SPX, RUT) contract
- Commission to expire worthless is 0.00 USD per contract (non-index and index)
- Commission to open or close non-option positions, if applicable, is 0.00 USD
- Slippage is calculated according to the slippage table
- Starting capital for short option backtests is adjusted in $1000 increments such that max margin utilization is between 80-100%, closest to 100%, of max margin utilization target
- Starting capital for long option backtests is adjusted in $1000 increments such that max drawdown is between 80-100%, closest to 100%, of max drawdown target
- Positions that have an exit date beyond the backtest end date are excluded
- For comprehensive details, visit the methodology page
Starting capital requirements of the s4 = TRUE strategies were lower than the daily-entry strategies. 7 DTE was an exception.
Hindsight bias was used to maximize Reg-T margin utilization for each strategy. This allows a “best case” scenario for the option strategy to outperform the benchmark.
Also displayed is the date in which each strategy experienced maximum margin utilization.
Max Drawdown Duration
Average Trade Duration
The average trade duration for all strategies was consistent across strategies.
Compound Annual Growth Rate
Profit Spent on Commission
The results of opening positions only on the days in which the s4 signal = TRUE is compelling. Let’s take a look under the hood and see what’s happening in a bit more detail. In the comparison we’ll look at buy/hold IWM, opening a 45 DTE 50-delta short put daily, opening a 45 DTE 50-delta short put only on days when s4 = TRUE, and opening a 45 DTE 50-delta short put only on days when s4 = FALSE.
Starting Capital and Leverage
Trading exclusively when the s4 = TRUE required less starting capital to successfully execute the strategy vs when s4 = FALSE or daily entry.
Win Rate Stats
The s4 = TRUE strat has just under 57% ( 2220 / 3899 ) of the number of occurrences vs daily entry.
Profit and Loss Stats
The s4 signal = TRUE strat yielded over 7% greater income vs daily entry [while placing roughly half as many trades as daily entry].
The s4 signal = FALSE strat managed to have a negative total PnL. Holding cash and not trading would have been more profitable.
Risk adjusted return when s4 = TRUE is 209% greater (2.1x) than daily entry.
Max drawdown when s4 = TRUE is 52% shallower vs daily entry. s4 = TRUE also recovers from the max drawdown much faster.
Limiting order entry to days in which the s4 signal = TRUE yields a greater total return vs a daily-entry strategy while materially lowering max drawdown, annualized volatility, commission drag and consequently boosting premium capture and risk-adjusted return.
Think about it for a moment. An investor traded roughly half as often and generated a greater total return. There’s no need to swing at every pitch; open a position only when it’s worthwhile and avoid the days that were more likely to experience a drawdown event.
Distribution of s4 signals
The s4 = TRUE signal, while suggesting order entry on roughly half the trading days since 2007, is not evenly distributed throughout time. Here’s a breakdown of participation rate by year:
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