SPY Long Put 90 DTE 30% OTM Tail Hedging

5 min read

From time to time clients authorize publication of their thesis, trade mechanics and backtest results. This is one such publication. I received compensation to perform this backtest but no discounts or “perks” were offered in return for authorization to publish.

The thesis behind this study starts with a tail-hedging publication from fellow quant researcher Corey Hoffstein and is part two to the SPY Long Put 90 DTE 10% and 30% OTM Tail Hedging study.

Sidebar: the methodology in Corey’s research uses “a quadratic curve to log-moneyness and implied total variance for each quoted maturity.” That’s a fancy way of saying: “uses a model to generate theoretical pricing,” which is then backtested. The methodology here at spintwig is entirely empirical; no theoretical data is used. There are tradeoffs between each approach but they should yield results in the same ballpark.

My interpretation of part 1’s data is that it suggests there is indeed an improvement in hedge effectiveness by monetizing vega movement (30% OTM) instead of delta movement (10% OTM). The client agreed with this interpretation.

With this finding confirmed both theoretically (Corey) and empirically (spintwig), the client was interested in exploring variations of the 30% OTM strategy. The baseline performance is to open a SPY long put at 90DTE, close at 60DTE then open another 90DTE position (roll every 30 days).

Explorative research is heuristic in nature. The client and I reviewed the SPY Long Put 45DTE Optimal Hedging and SPY Long Call 45DTE backtests and noted that managing positions at 50% appreciation and 10% appreciation in option price, respectively, yielded the best results. Thus, we used those as early-management targets and threw in 25% to split the difference in the event something interesting happens at that target.

In this post we’ll take a look at the 30% OTM strategy results. Specifically, the backtest results of opening one SPY long put 90 DTE 30% OTM each month and exiting when any of the following conditions is met:

• DTE = 60
• 10% appreciation in option price
• 25% appreciation in option price
• 50% appreciation in option price

Backtest duration is from Jan 3 2007 through Aug 28 2020.

There are 4 backtests in this study evaluating over 800 SPY long put 90 DTE 30% OTM trades.

Let’s dive in!

Summary

It appears that implementing a mechanical profit-taker at various targets did not improve the 30% OTM strat’s effectiveness as a tail hedge.

As shown by the math in the risk management section, the cost to implement a ~100% hedge isn’t terribly expensive.

Methodology

Strategy Details

• Symbol: SPY
• Strategy: Short Put
• Days Till Expiration: 90 DTE +/- 17, closest to 90
• Start Date: 2007-01-03
• End Date: 2020-08-28
• Positions opened per trade: 1
• Entry Days: roll
• Entry Signal: N/A
• Timing 3:46pm ET
• Strike Short Leg: 30% OTM +/- 500bps, closest to 30%
• Strike Long Leg: N/A
• Exit Logic: whichever occurs first
  • Exit Profit Target: 10%, 25% and 50% appreciation of option value
  • Exit DTE: 60
  • Exit Hold Days: N/A
  • Exit Stop Loss: N/A
  • Exit Signal: N/A
• Max Margin Utilization Target (short option strats only): N/A
• Max Drawdown Target: 99% | account value shall not go negative

Assumptions

• 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

Mechanics

• 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 0.35 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.
• For comprehensive details, visit the methodology page.

Results

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.”

Hindsight bias was used to realize the max drawdown target for each strategy. In this scenario, the max drawdown target was 99% per the “Strategy Details” section above.

The starting capital required to successfully execute each strategy is in the same ballpark.

Let’s see how they perform in detail.

Win Rate

There were roughly the same amount of trades in each early-management strategy.

The more aggressive the early management, the more trades are placed.

Profit / Loss

The strategies themselves are net negative. Said another way, these hedges cost money to implement and maintain.

What’s interesting here is that the total P/L at the time of backtest end for the 30% OTM strategy is not -90 to -99%.

Keep in mind that each strategy’s starting capital was selected using hindsight bias in order to realize a max drawdown value of 99%.

Long option strategies that end at -99% typically decay in a relatively smooth fashion until the account reaches $0 or otherwise is unable to support the purchase of another option contract. The impact of introducing profit takers and consequently increasing transaction count appears to do more harm than good.

Performance

Risk Management

Overall

The proprietary strategies demonstrated returns commensurate with the portfolio’s vomma exposure.

Discussion

This strategy was a play on the outer edge of the theta-decay curve. By opening positions 45DTE then closing them after, at most, 5 trading days, there is very little time for theta decay to occur. When coupled with a spread width of just 5 delta and an aggressive early-management strategy that prevents winners from running (early management of spreads can be considered a “double risk management” – once by structurally capping losses and once by variably caping time in the market), there is simply not enough premium retained after losses and commissions to turn a profit.

Additional Resources

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