When back-testing an options strategy I want to first test the potential profitability of the strategy against the best possible outcome. The home run outcome. If it doesn’t perform well under the best potential outcome then I can safely abandon the strategy and continue my search for a better one. Of course I also need to take into account whether or not that outcome has a reasonable likelihood of success. I’m not a probability trader since almost every single day I see many examples of stocks or indexes making price moves that far exceed their expected range but I also don’t buy far out-of-the-money (OTM) options for a few cents hoping that they will explode in value before they expire. That’s a losing strategy! This post is going to use the ThinkBack feature on ThinkorSwim (TOS) to illustrate that point as well as demonstrate a strategy to trade that move.
The first thing I want you to notice is the Delta on the Jan13 SPX 4000 Calls as of the close on Jan6. It was .18 or, in other words, had an 18% probability of being in-the-money (ITM) at expiration. If I was simply buying that Call it would’ve cost around $11 to buy and would’ve been worthless at expiry on Jan13 when SPX closed at 3999. So while that SPX rally from 3895 on Jan6 to 3999 on Jan13 had just an 18% probability of occurring, it would not have been a good strategy to buy an 18 Delta option to trade that.
Below is one of the better option strategies for trading the 100 point rally. It’s a Call Diagonal spread where the short option expires on Friday, Jan13 and the long option expires on Tuesday, Jan17. Normally the long option expires on the Monday following the Friday short option expiry but in this particular example the option market was closed on Monday so Tuesday was the closest option expiry to Friday. I use the Friday/Monday time spreads very frequently and I’ll put a link to the post that discusses the strategy more in-depth down below at the end of this post.
In the above example of a Diagonal spread, the cost was $920 and if held to expiry the profit would’ve been $2,245 which makes that a pretty good trade! Below is a strategy that I refer to as a RS+. I’ll also put a link to the post that discusses the RS+ strategy more in-depth down below at the end of this post. For purposes of understanding the results below you can view the RS+ as a combination of Call Vertical Spread and a Calendar spread. That trade would’ve cost $1,145 and if held to expiry the profit would’ve been $4,214. So compared to the Diagonal spread, the cost was 24% higher but the profit was 88% higher. 🤔 That’s assuming that both trades were held until expiry and no Delta Hedging (DH’ing) was done. Let’s take a look at how the DH’ing strategy would have worked out.
In the example below, if I would’ve waited until just prior to the close of the day that I could’ve gotten at least all of the initial risk out of the trade (I refer to that condition as zero cost), I could’ve rolled the Call Diagonal up into a Call Calendar spread by selling a $25-wide Vertical spread in the Jan17 expiry for more than what I originally paid for the Diagonal ($920). In this case, selling the Vertical on Jan11 would’ve generated a $1,205 Credit so my net cost would’ve then been a $285 Credit ($920-$1,205). That becomes the minimum profit of the trade. The current profit as of the close on Jan11 was $735.
On Jan11, I could’ve also gotten to zero cost (or better, locking-in a minimum profit) on the RS+. That trade cost $1,145 and I could’ve rolled up the strike on the Jan13 expiry Calls by selling (to close) the $25-wide Call Vertical spread for a $1,210 Credit so my net cost would’ve then been a $65 Credit ($1,145-$1,210). That becomes the minimum profit of the trade. The current profit as of the close on Jan11 was $965.
Now I’m going to ask you to go back and look at the total profit of the two different strategies on the previous 2 risk profiles above. The total profit of the positions is shown in yellow on the upper left hand side of the chart. Using the DH strategy the total profit of the Diagonal spread would’ve been $1,760 and the total profit of the RS+ would’ve been $3,015. Why the big difference? The RS+ actually has *2* Calendar spreads left after the DH trade whereas the Diagonal has just 1 remaining. Now, let’s discuss one more variation (below) since I’m sure you’re wondering how would 1 Diagonal and 1 Calendar have fared? Below is that profit graph. Not bad at all but still less than my personal favorite, the RS+.
I’m not here to tell anyone how to trade. My goal is to get you to think! Take the information that I’ve given you and work with it to make it your own. Come up with even better strategies than I’ve presented and then come back here and share them with the community!
Below are those links I promised you.
The 3 Day Rule – ITM Diagonals aka 3-Day Spreads – The Call RS+ (Paul) – The Call RS+ (Travis)
Questions or comments? Leave them down below. I appreciate any comments, good or bad, because that’s how I know if this post is helpful or not.