April 28, 2023

Short IWM Put 7 DTE s4 signal Options Backtest

spintwig.com Options 7 DTE, backtest, Hold Till Expiration, IWM/RUT, Leveraged, s4 signal, Short Put 0

4 min read

In this post we’ll take a look at the backtest results of opening one short IWM put 7 DTE position each trading day from Jun 1 2010 through Mar 31 2023 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 options on the Russell 2000 were introduced mid May 2010 on IWM and mid March 2011 on RUT. Therefore, backtests will be performed using IWM as the underlying as there is greater historical data available.

This study seeks to explore the following theses:

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, with regard to capital efficiency, a strategy that opens and holds-till-expiration every trading day
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, with regard to capital efficiency, a strategy that opens and holds-till-expiration every trading day
the s4 = true 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 with regard to capital efficiency
limit order entry to only the days in which s4 = FALSE to see if the strategy underperforms daily entry with regard to capital efficiency
compare performance of s4 = TRUE strats against a 100% IWM buy/hold portfolio with dividends reinvested (total return) to see if the option strats outperform a buy-and-hold portfolio

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 31,300 short IWM put 7 DTE leveraged trades.

Let’s dive in!

Summary

Thesis 1: the s4 signal, when true, yielded up to a 34% improvement in capital efficiency vs a “market-agnostic” daily short-put strategy. It also improved premium capture by up to 40% vs daily entry.

Thesis 2: the s4 signal, when false, yielded up to a 75% deterioration in capital efficiency vs a “market-agnostic” daily short-put strategy. It also impaired premium capture by up to 44% vs daily entry.

Thesis 3: the s4 signal, when true and leveraged (30-delta, max leverage of 5x), yielded up to twice the total return vs buy-and-hold IWM with dividends reinvested (total return). The same option strategy accomplished this with an 86% greater sharpe ratio but with a 61% deeper max drawdown. Despite the deeper max drawdown vs buy-and-hold, max drawdown duration was 21% shorter.

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Methodology

Strategy Details

Symbol: IWM
Strategy: Short Put
Days Till Expiration: 7 DTE +/- 4, closest to 7
Start Date: 2010-06-01
End Date: 2023-03-31
Positions opened per trade: 1
Entry Days:
- each trading day
- each trading day in which the s4 signal = TRUE
- each trading day in which the s4 signal = FALSE
Entry Signal: s4 signal
Timing 3:46pm ET
Strike Selection
- 5 delta +/- 4.5, closest to 5
- 10 delta +/- 5, closest to 10
- 16 delta +/- 6, closest to 16
- 30 delta +/- 8, closest to 30
- 50 delta +/- 8, closest to 50
Trade Entry
- 5D short put
- 10D short put
- 16D short put
- 30D short put
- 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

Assumptions

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 set using hindsight bias so that max margin utilization never exceeds 100%)
Apply a 20% discount to displayed results. For example, if a strat depicts a CAGR of 10%, assume that it’ll yield 8% in practice.

Mechanics

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 PnL 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

Results

Starting Capital

Margin Utilization

Short IWM Put 7 DTE max margin utilization table

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 by identifying the minimum amount of starting capital necessary to successfully (eg: avoid margin calls) complete the backtest.

Premium Capture

Win Rate

Monthly Returns

Short IWM Put 7 DTE average monthly pnl table

Short IWM Put 7 DTE monthly returns table

Max Drawdown

Max Drawdown Duration

Average Trade Duration

Average Trade Delta

Compound Annual Growth Rate

Annual Volatility

Sharpe Ratio

Profit Spent on Commission

Capital Efficiency

Total PnL

Overall

Discussion

The 7-DTE strategies are on edge of effectiveness, consistent with the 7-DTE to 365-DTE s4 signal study‘s capital efficiency metrics. Longer-duration strategies have historically demonstrated greater capital efficiency. Nevertheless, there is still outperformance with regard to capital efficiency when selling 7-DTE puts at nearly all strikes when s4 = true vs daily entry. Similarly, there is underperformance with regard to capital efficiency when selling puts when s4 = false vs daily entry.

Let’s take a look under the hood and see what’s happening in a bit more detail. We’ll look at buy-and-hold IWM with dividends reinvested (i.e. total return), opening a 30-delta short put daily, opening a 30-delta short put only on days when s4 = TRUE, and opening a 30-delta short put only on days when s4 = FALSE.

Starting Capital and Leverage

Trading exclusively when the s4 signal = TRUE required roughly the same amount of starting capital as daily entry to successfully execute the strategy at a max-leverage target of 5x, without margin calls, for the duration of the backtest.

Win Rate Stats

The s4 signal = TRUE strat had roughly half ( 1657 / 3139 ) of the number of occurrences vs daily entry and experienced a greater average win and smaller average loss.

Profit and Loss Stats

The s4 signal = TRUE strat yielded 73% of the income vs daily entry while placing 47% fewer trades. More concisely, s4 signal = TTRUE improved premium capture by 40% ( 30.64 / 21.88 – 1 ).

Performance Stats

The s4 signal = TRUE strat yielded ~40% greater average PnL per trade and average PnL per day per position vs daily entry.

Risk Management

The s4 signal = TRUE strat yielded ~20% shorter max drawdown duration.

This is a scenario where improved capital efficiency didn’t coincide with greater total or risk-adjusted return. And that’s okay! Some traders seek to maximize total return above all else. Others may seek to maximize risk-adjusted return. Still others may seek to maximize capital efficiency.

In a portfolio of diversified strategies, it may be optimal to select the most capital efficient trades based on prevailing objectives, mandates and/or capital constraints.

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: