Short SPX Put 3-DTE s1 signal Options Backtest

6 min read

Short-dated options have been discussed many times in financial media in 2023. For a short background, Friday-expiring weeily options on SPX were introduced on October 28 2005. Then, Wednesday-expiring weekly options on SPX (see CBOE Regulatory Circular RG16-024) were introduced on February 23 2016. Fewer than six months later, Monday-expiring weekly options on SPX were introduced (see CBOE Regulatory Circular RG-16-119) on August 15 2016. Finally, six years later, Tuesday-expiring and Thursday-expiring weekly options on SPX (see CBOE reference C2022091501) were introduced on September 19 2022 and September 28 2022, respectively. There are now SPX option expirations occurring every weekday.

Option positions opened with 7 days till expiration (DTE) are generally described as “short-duration” option positions. Logic would follow that option positions opened with fewer than 7 DTE would be described as “ultra-short-duration”. This study seeks to explore the performance of ultra-short-duration option strats, defined as option positions opened with an average of 3 DTE.

We’ll take a look at the backtest results of opening one short SPX put 3-DTE position each trading day from March 1 2016 through April 30 2023 and see if there are any discernible trends. March 1 2016 is the fist full month in which an average DTE of 3 can be obtained while mitigating timing luck. Delta targets include 5, 10, 16, 30, 50 (at the money), and 90 (far ITM, long SPX proxy).

We will also explore the performance of the s1 signal. The s1 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 S&P 500 are most likely to be profitable at expiration. s1 is based on data from Cboe and S&P Global.

The s1 signal has yielded material improvements in total return, risk-adjusted return, max drawdown, and capital efficiency when selling puts on the S&P 500 vs a “market-agnostic” daily-entry strategy. That is, it avoids opening positions on days in which the realized [downward] movement (RV) is anticipated to be greater at expiration than the implied [downward] movement (IV). When the S&P 500 experiences downward movements in excess of the market’s expectations (i.e. RV > IV), short put options whose [downward] IV has been exceeded at expiration lose money. Let’s see if the s1 signal can help traders avoid these expectation-exceeding trades on S&P 500.

This study seeks to explore the following theses:

1. if we open and hold-till-expiration a short SPX put 3-DTE position on the days in which s1 is TRUE, and take no action on the days in which s1 is FALSE, we will outperform, with regard to capital efficiency, a strategy that opens and holds-till-expiration every trading day
2. if we open and hold-till-expiration a short SPX put 3-DTE position on the days in which s1 is FALSE, and take no action on the days in which s1 is TRUE, we will underperform, with regard to capital efficiency, a strategy that opens and holds-till-expiration every trading day
3. applying the s1 = TRUE signal to a leveraged short SPX put 3-DTE strat can outperform a 100% SPY buy-and-hold portfolio with dividends reinvested (total return) with regard to total return, risk-adjusted return, and max drawdown

To test these theses we will:

1. limit order entry to only the days in which s1 = TRUE to see if the strategy outperforms daily entry with regard to capital efficiency
2. limit order entry to only the days in which s1 = FALSE to see if the strategy underperforms daily entry with regard to capital efficiency
3. compare performance of s1 = TRUE strats against a 100% SPY buy-and-hold portfolio with dividends reinvested (total return) to see if the option strats outperform a buy-and-hold portfolio

Performance of the s1 signal is explored in different contexts in other non-paywalled s1 signal studies.

There are 18 backtests in this study evaluating over 21,300 short SPX put 3-DTE leveraged trades.

Let’s dive in!

Summary

Thesis 1: the s1 signal, when true, yielded up to a 276% (3.8x) improvement in capital efficiency vs a “market-agnostic” daily-entry strategy. It also improved premium capture by up to 290% (3.9x) vs daily entry.

Thesis 2: the s1 signal, when false, yielded up to a -169% (-2.7x) deterioration in capital efficiency (experienced negative PnL) vs a “market-agnostic” daily-entry strategy. It also impaired premium capture by up to -255% (-3.6x) (experienced negative premium capture) vs daily entry.

Thesis 3: the s1 signal, when true and leveraged (30-delta, max leverage of 5x), yielded 97% of the total return of buy-and-hold SPY with dividends reinvested (total return). The same option strategy accomplished this with a 48% greater sharpe ratio and with a 41% shallower max drawdown. Complimenting the shallower max drawdown vs buy-and-hold, max drawdown duration was 66 days while buy-and-hold has yet to recover.

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Methodology

Strategy Details

• Symbol: SPX
• Strategy: Short Put
• Days Till Expiration: 3 DTE +/- 2, closest to 3
• Start Date: 2016-03-01
• End Date: 2023-04-30
• Positions opened per trade: 1
• Entry Days:
  • each trading day
  • each trading day in which the s1 signal = TRUE
  • each trading day in which the s1 signal = FALSE
• Entry Signal: s1 signal
• Timing 3:46pm ET
• Strike Selection
  • 5 delta +/- 4, 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
  • 90 delta +/-8, closest to 90
• Trade Entry
  • 5-delta short put
  • 10-delta short put
  • 16-delta short put
  • 30-delta short put
  • 50-delta short put
  • 90-delta 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, where the short option expires after the long option, is 20% of the short option
• Margin requirement for long CALENDAR SPREAD positions, where the short options expires before the long option, is the net cost of the spread
• 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
• Option positions are opened at 3:46pm ET
• Option positions are closed at 3:46pm ET (4:00pm if closed on the date of expiration)
• Commission to open, close early, or expire ITM is 1.00 USD per non-index underlying (eg: SPY, IWM, AAPL, etc.) contract
• Commission to open, close early, or expire ITM is 1.32 USD per index underlying (eg: SPX, RUT, etc.) 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

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

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

Sidebar: for readers familiar with my collaboration with fellow blogger Dr. Karsten at Early Retirement Now (ERN), this study can be considered an extension and update to the 2021 guest post: Passive income through option writing: Part 9 – 2016-2021 backtest: Guest Post by “Spintwig”.

Short volatility strats have a tendency to generate small and consistent profits with occasional outsized losses that can wipe out months or years of profits in a single trade. Rather than trying to completely avoid these losing trades (the s1 signal does a great job of avoiding several of them), which is an impossible task, a better approach would be to make the trade less asymmetric.

To make a short-option trade less asymmetric, one would target a greater delta at order entry. We can observe this effect when looking at the average win and average loss across delta targets.

The ratio of average loss to average win can be used as a proxy for [a]symmetry. The 5-delta strats experience ratios in the 14-26x range. That is, a single loss, on average, wipes out 14 to 26 wins. As we work our way closer to the money and in the money, the ratio decreases to the 1.2-1.4x range. That is, a single loss, on average, wipes out “only” 1.2 to 1.4 wins.

Let’s take a closer look at the 30-delta short SPX put 3-DTE trade. We’ll start by comparing the benchmark – buy-and-hold SPY with dividends reinvested (total return) – to opening a 30-delta short put daily, opening a 30-delta short put only on days when s1 = TRUE, and opening a 30-delta short put only on days when s1 = FALSE.

Starting Capital and Leverage

Trading exclusively when the s1 signal = TRUE required 5% greater starting capital vs daily entry to successfully execute the strategy at a max-leverage target of 5x, without margin calls, for the duration of the backtest.

Let’s take a look at historical margin utilization rates of the s1 implementation. It averaged just over 20% margin utilization, or just over 1x leverage. Of course, there were times when max margin utilization was 100% / 5x leverage.

Win Rate Stats

The s1 signal = TRUE strat had less than half ( 865 / 1779 ) of the number of occurrences vs daily entry and experienced roughly the same average win but with a 15% smaller average loss.

Profit and Loss Stats

The s1 signal = TRUE strat yielded 5% greater strategy income vs daily entry while placing 51% fewer trades. More concisely, s1 signal = TRUE improved premium capture by 119% ( 27.59 / 12.58 – 1 ).

Performance Stats

The s1 signal = TRUE strat yielded 116% greater average PnL per trade and average PnL per day per position vs daily entry.

Risk Management

The s1 signal = TRUE strat yielded a 51% shallower max drawdown and an infinitely shorter max drawdown duration vs daily entry.

Distribution of s1 signals

The s1 = 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:

The historical s1 signal boolean values are available for download in the trade log store.

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Additional Resources

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Trade Logs

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