The strategy changes we’ve been developing and testing since last month’s drawdown are proving to be enormously beneficial. We’ve completed backtesting from October 2009 through December 2010, and the difference between what I’ll call the new “Vega-Hedged Strategy” and the existing strategy’s historic performance is astonishing. Our average quarterly return for the past 15 months was 7.95%, and the standard deviation of returns was about 10%. The Vega-Hedged strategy, with delta-based risk-management triggers, showed an average quarterly return of 19.24% over the same period, with a standard deviation of 7%. Only one month (November 2010, of course) booked a loss, and the annualized return for the tested period was almost 125%.
The chart below summarizes the results:
Bear in mind that our testing goes back only a little more than one year. It includes the “Flash Crash” and some very volatile correction and breakout periods—but it doesn’t cover the ’08/’09 crash and spring 2009 bounceback. The trade-entry rules we already have in place would have kept us in cash through most of the credit crisis, and presumably, the tighter, delta-based risk-management thresholds included in the improved strategy would’ve been beneficial in the initial, March-April 2009 bounce—but we have yet to backtest those market extremes. Nevertheless, we have sufficient grounds for adopting the latest experimental rule changes.
The New Regime
The key to our latest strategy enhancements is hedging vega as well as delta. When the market is in a sell-off and implied volatility is spiking, we’re going to sell volatility, using butterfly trades for hedging. And instead of picking risk-management price thresholds based on the expiration profit/loss profile, we’re adopting a dynamic, delta-based approach. Here’s a summary of this latest round of strategy changes:
- A more objective, quantitative approach to adjustment triggers: ~5% of capital at risk on the downside and ~2.5% of capital at risk on the upside.
- More aggressive risk management:
- Negative-vega hedging strategy (butterfly) for short-term spikes in IV, especially near expiration and especially when IV skews heavily toward short-term protection;
- Neutral portfolio-delta target when adjusting for upside moves;
- No more overnight whipsaw-filter rule (trade on intraday trigger if still valid in late afternoon).
- Consider vertical volatility skew as well as horizontal (month-to-month) skew when constructing new positions.
Even with the new vega-hedging strategy, it’s important to remember that calendar spreads have a lot more positive vega per dollar at risk than iron condors. Consequently, we commit no more than one-third of options-income capital to the Calendar Options strategy (including cash set aside for adjustments).
Regarding Supplemental Trades, we’re going to avoid dividends for high-yield stocks, as well as earnings. More important, we’re going to favor ETFs over individual stocks from here on out. A skilled trader can apply what s/he’s learned from this newsletter to individual stocks under the right circumstances, and we aren’t going to abandon Supplemental Trades on corporate equities; we’re just going to favor ETFs given similar risk profiles, and we’ll limit our company searches to stocks that have yields below 2% (or don’t go ex-dividend in the cycle).
We know this is a lot to absorb, especially for new members, so don’t hesitate to e-mail email@example.com if you have any questions after reviewing the past few weeks’ posts.