In my last post I presented everyone with an entirely new way to view options trading. Instead of trading singular options positions, why shouldn’t we trade options similar to an ETF fund manager? Simplistically speaking, we identify a basket of assets for long spreads and hedge away the downside with a countering short spread. While the thought has certainly peaked my interest, I’m not quite ready to begin committing real money to the strategy. I did however, construct several “fund” baskets using ThinkorSwim paper money so I can watch how the positions develop over time.
That said, in an effort to understand the complexities at work while trading this method I believe a thorough round of back testing is needed. So, in today’s post I’m going to conduct the following options ETF back test’s.
- 1 year back test
- 3 year back test
- 5 year back test
These, at minimum, will provide the methodology’s framework, as well as possible profit/loss expectations. If I’m lucky, I’ll also uncover a mechanical approach to implementation. Though, that seems to be an elusive goal at best. For the sake of simplicity, and to avoid any curb fitting, I’ll eliminate all management criteria throughout the testing. However, once each options ETF back test is complete, I’ll use the resulting data to discuss potential management techniques.
Universal Back Testing Rules
- Long Spread Days to Expiration – 300+
- Short Spread Days to Expiration – 150+
- Each Long Spread cost is less than half the strike width.
- Short Spread risk cannot exceed total cost of all long spreads.
- Minimum of 5 Spreads in each Options ETF
Universal Back Testing Assets
To keep the test’s fair and orderly I’ll limit the stocks I’m trading to those I hold as long term assets in my IRA. They are;
- AMZN
- GOOG
- CP
- MCD
- V
- CVX
- MSFT
- WMT
- WM
- O
- TXRH
- XLU
- KO
- AFL
- PFE
- SPY
Options ETF Back Test – 1 Year
For the first options ETF back test we’ll open the smallest possible combination of trades. We’ll use 4 long spreads and 1 short SPY spread. Each long spread will come from a different sector to minimize correlation and/or improve diversification. Therefore, in this test, let’s use Microsoft, Aflac, Walmart, and Waste Management. That will provide us exposure to technology, financial, consumer staples, and the industrial sectors, respectively. Before I begin, it may also be prudent in live trading to consider which sectors have been seeing the most strength recently. That may provide some additional tail wind to our basket of trades. To do so, I’d simply view the groups tab on Finviz.com.
- Total cost for all long spreads – $850
- Total credit from short SPY spread – $449
- Total Risk – $951
| Month | $ Return |
| 1 | ($36.50) |
| 2 | $122.00 |
| 3 | $189.00 |
| 4 | $272.50 |
| 5 | $445.00 |
| 6 | $514.00 |
| 7 | $510.50 |
| 8 | $561.50 |
| 9 | $534.00 |
| 10 | $569.00 |
| 11 | $697.50 |
| 12 | $549.00 |
Year 1 Thoughts
Well that was much more successful than I’d anticipated it might be. However, as you’ll notice in the second half of the year the returns seemed to plateau between the $500 – $600 dollar range. While the final month saw a larger increase I don’t believe that would be a common occurrence. I think the testing period was just particularly bullish which forced the ETF higher immediately. Further, every long spread reached maximum profit and the short SPY spread was virtually a max loss.
Going forward, I think the opportunity cost would be greater than the possible profit to be gained by leaving the trades open. Once the options ETF is in the ballpark of its maximum profit, that may very well be the appropriate time to close the trades and reopen another basket of trades. Afterall, we are using options and they have that pesky tendency to decay.
Options ETF Back Test – 3 Years
With the wildly successful 1 year test complete I’m fully expecting this test to be more “realistic”. In this round of testing I’ll have to open and close several positions throughout the testing period so that my ETF is open for the entire test. In reality, that may not be the safest approach but we’ll see what is uncovered.
As agreed, I’m not looking to manage any of the positions during this test. However, I’ll have to submit this round of testing to at least rolling the position before expiration. Therefore, I’ll simply close the open spread and reopen a new spread in the month prior to the expiration month. For example, if the spread expires in December, I’ll be rolling it during November. At each roll, I’ll open another position following the rules provided above.
Finally, I’ll differentiate this test by opening 3 additional long spreads or 7 total longs and 1 short spread on SPY as my hedge. The assets I’ll trade here are; Visa, Mcdonald’s, Chevron, Aflac, Realty Income, Microsoft, and Coca-Cola.
- Total Initial Cost for Long Spreads – $1,317
- Total Initial Credit for Short SPY Spread – $833
- Total Initial Risk – $1,150
| Period | $ Return |
| 6 Months | $844.50 |
| 1 Year | $796.50 |
| 1 Year 6 Months | $398.00 |
| 2 Years | $188.00 |
| 2 Years 6 Months | $770.00 |
| 3 Years | $1,865.00 |
Well, I’ll start by saying this strategy is proving to be even more promising than I could’ve hoped. That said, I need to temper my giddiness though because as we all know, the past is no indication of the future. This test started in January of 2019, as did the 1 year test. Which means throughout this round of testing we traded through the covid fall out and still came out with more than 100% profit when compared with the risk we had at any given time.
Microsoft and McDonalds did the bulk of the lifting during the 3 year period with each asset earning over $1,000 in profit. Chevron on the other hand was the most under performing asset returning just $143 during the 3 years. Every other asset was between $250 and $450 throughout the test. Not great but not awful either, and none of the assets bolstered a negative return which was surprising. However, my hedged SPY position was dramatically negative, returning -$1,840 during the 3 year period.
Had I attempted to time the market through the covid drop I may have been able to noticeably minimize my losses on SPY but that would require some level of skill or foresight. Both of which I don’t have a great track record with. Other than that, the only other management technique I could reasonably conclude would be the removal of under performers. Also, it may always make sense to know which sectors are performing the best and rotate those under performers into sectors performing well.
In any case, the test was more than profitable on a limited amount of risk and I can’t be upset about it. In the next test we’ll swing for the fences and really open this strategy up.
Options ETF Back Test – 5 Years
Both the 1 year and 3 year back tests have proven profitable. For this last round of testing I’m going to start with 10 positions and remove under performers at each 6 month check. This may result in further under performance but it also may help to avoid the true losers of the bunch. Additionally, I’ll open up my potential asset base by using my master options list. This list houses some 200 different assets but I’ll at least only choose household names for the test.
Similar to the 3 year test I’ll roll the position prior to the expiration month to avoid any unnecessary theta decay and to maintain a position at all times. Furthermore, I’m going to move the SPY short spread further OTM and double my lot size. This will maintain essentially the same credit but will hopefully mitigate some of the losses. I guess we’ll see,
To begin, I’ll open the following assets; IWM, GLD, TLT, NKE, MSFT, MCD, HD, V, MA, & SBUX. I have selected Microsoft and McDonald’s yet again for the test which we know performed well. However, I didn’t do it because they performed well but simply because of every stock in existence, they are my favorite with Visa coming in as a close third. Which I also selected for this test.
Let’s see how it goes.
- Total Initial Cost for Long Spreads – $1,773
- Total Initial Credit for Short SPY Spreads – $1030
- Total Initial Risk – $1,712
| Period | $ Return |
| 6 Months | $1,653.00 |
| 1 Year | $2,483.50 |
| 1 Year 6 Months | $3,073.50 |
| 2 Years | $4,072.00 |
| 2 Years 6 Months | $4,305.50 |
| 3 Years | $4,019.00 |
| 3 Years 6 Months | $4,054.50 |
| 4 Years | $3,689.00 |
| 4 Years 6 Months | $3,377.00 |
| 5 Years | $2,986.50 |
Throughout the 5 year period TLT was the woeful under performer adding a total of $202 to the bottom line. Funny enough, McDonald’s wasn’t much further ahead at $484. However, most positions were between $400 and $800 for the entire period. The top performers were Microsoft and Mastercard each adding over $1,000 to the total. Finally, worth mentioning, is again no single position returned a net negative outside of the hedge with SPY.
Now, to dramatically improve performance something will need to be doe with regards to SPY. I’m noticing that in every test the hedge was becoming increasingly more costly. Even during 2022 I was only able to close the SPY trade once for a max profit. When I opened the next one it quickly went ITM and became a drag on the ETF.
All together, I never had over the initial risk amount of $1,700 so the final return is still north of 100% which is remarkable. Scale that up and the dollar return becomes even more staggering but so does the risk and I’m not really sure about that. The market period from 2019 – 2024 was overall very bullish with 2021 and 2023 performing overly well.
Final Thoughts about the Options ETF Back Test
I’m excited about it to say the least. While there certainly needs to be additional testing, this may be the first back test I’ve ever completed in which every test was profitable. Additionally, there was virtually no management necessary which makes the possibilities even more intriguing.
When considering each test one thing stands out above any other and that’s with regard to the SPY hedge. It will need to be micro managed on a more consistent basis should the market continue to roar higher. Should we face a prolonged bear market in the years ahead then the outcome for it won’t seem so detrimental to the ETF. That said, 2022 was entirely bearish but that did little to curb the losses I sustained by opening the hedge. The future is unknown so likely I wouldn’t attempt the strategy without a hedge but doing something to minimize it’s impact while still protecting the position would be nice. I’ll be looking into just that as I monitor my paper trades.
Finally, I’m more than a little relieved to know that options trading doesn’t have to be immensely complicated and that this largely passive strategy has performed so well. I’ve traded some very complex positions over the years that require constant babysitting so this is certainly a refreshing change of pace.
In closing, 3 things are clear, in my opinion, from this back test.
- Micro-management of the SPY hedge or another hedge is a must to temper losses.
- Identify the strong assets. Those I’d be willing to invest in long term. (May produce even better returns by opening spreads within the ETF as these assets dip in price.)
- Identify which sectors of the economy are in favor and open positions in those assets. (Again, maybe on a dip in price.)
Using these 3 criteria should produce even better results and as I continue to evaluate the options ETF strategy I’ll be focused on creating rules that both protect capital and improve returns.
God bless,
Jeff
