In this post we’ll take a look at the backtest results of an SPX poor-man’s covered call (PMCC) strategy from Jan 3 2007 through April 30 2021 and see if there are any discernible trends. This strategy will be benchmarked against buy-and-hold SPY.
A traditional covered-call strategy involves holding 100 shares of long underlying and selling a short call option against the long position. A less-capital-intensive, although not exactly a 1:1, alternative to holding 100 shares of underlying is to buy a deep-in-the-money call option. In both configurations, the idea is that one can generate cash flow by selling calls while the long position prevents an “unlimited loss” scenario from occurring.
Prior research suggests that SPY 45 DTE short calls have a negative expected value (they consistently lose money). However, research on shorter-dated SPY 0 DTE short calls suggests systematic positive returns are indeed possible. In this backtest we’ll split the difference and explore weekly options.
- open a 120 DTE 85-delta long-call position then roll to a fresh 120 DTE 85-delta long call at expiration
- sell 7 DTE 5-delta short calls, held till expiration, against the long call
- if/when the short call expires in the money (ITM), both positions are exited and fresh 120 DTE 85-delta long call and 7 DTE 5-delta short call positions are opened
The backtest uses SPX as the underlying because there is more historical data for SPX than SPY (weeklies were introduced in 2005 for SPX vs 2010 for SPY). However, SPY is a more-accessible underlying due to its smaller notional value. Anyone that wants the backtest numbers for SPY can simply divide depicted dollar amounts (starting capital, best/worst trade, etc.) by 10.
NOTE 1: I have adjusted commissions to assume SPY is being traded. Performance for SPX will be slightly better vs what’s depicted due to improved commission efficiency of SPX. For more info regarding commission efficiency across similar instruments, check out my guest post over on BigERN’s blog.
NOTE 2: Each leg of the PMCC has been calculated independently (i.e. two separate Reg-T accounts, one for each leg). This is to allow full transparency into each leg’s performance and margin requirements. The PMCC calculations are a reflection of the net monthly P/L for each leg. Consolidated performance may require more or less capital and may reflect more or less interest earned depending on an individual trader’s account configuration and the broker’s margin requirements in excess of Reg-T (i.e. the “house rules”).
NOTE 3: There are many ways to implement a PMCC strategy. This instance can serve as a proxy for all reasonable configurations.
Let’s dive in!
Systematically implementing the poor man’s covered call was profitable at the conclusion of the backtest.
The poor man’s covered call (PMCC) strategy did not outperform SPY with regard to total return.
- Symbol: SPX
- Strategy: Poor Man’s Covered Call (PMCC)
- Days Till Expiration: 7 DTE +/- 4, closest to 7 and 120 DTE +/- 30, closest to 120
- Start Date: 2007-01-03
- End Date: 2021-04-30
- Positions opened per trade: 1
- Entry Days: roll
- Entry Signal: N/A
- Timing 3:46pm ET
- Strike Short Leg: 5D +/- 4.5, closest to 5
- Strike Long Leg: 85D +/- 5, closest to 85
- Exit Logic: whichever occurs first
- Exit Profit Target: N/A
- Exit DTE: Expiration
- Exit Hold Days: N/A
- Exit Stop Loss: N/A
- Exit Signal: when short call expires ITM
- Max Margin Utilization Target (short option strats only): 99%
- Max Drawdown Target: 99% | account value shall not go negative
- Margin requirements are always satisfied
- Margin calls never occur
- 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
- Early assignment never occurs
- Prices are in USD
- Prices are nominal (not adjusted for inflation)
- 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 expiration / position exit
- Commission to open, close early, or expire ITM is 1.00 USD per contract
- Commission to expire worthless is 0.00 USD per contract
- 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 $100 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 $100 increments such that max drawdown is between 80-100%, closest to 100%, of max drawdown target.
- Positions that are open at the end of the backtest are closed and their P/L is recorded on the date of closure.
- For comprehensive details, visit the methodology page.
Starting Capital and Leverage
Long option strategies aren’t traded on margin (not to be confused with generating a margin loan to purchase an option). Thus, margin stats are all “N/A” for the long call portion of the poor man’s covered call.
Hindsight bias was used to realize the max drawdown target for the long call portion of the strategy. In this scenario, the max drawdown target was 99% per the “Strategy Details” section above.
Similarly, the short option leg had its starting capital calculated with a max margin utilization target of 100% (5x leverage). This is the ceiling for Reg-T margin accounts.
Let’s see how the legs perform in detail.
The 5-delta short call was cycled each week. There were 3 trades with “dirt” that were left as is, as depicted by the early management trades.
The 85-delta long call was cycled each time the short call expired ITM. Otherwise, it was held till expiration.
Profit / Loss
About a quarter of the short call leg’s income is from the interest earned on the 3-month t-bill collateral.
Similarly, about a quarter of the total income was lost to commissions.
All legs of the poor man’s covered call were eventually profitable.
This strategy is essentially a debit calendar spread. The long-dated leg serves as a proxy for the underlying, complete with friction costs (theta decay, non 1:1 movement with the underlying, etc). The short-dated leg serves as the vehicle for the covered call, business as usual.
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