Ok, the results are in! First, a few disclaimers: This is based on backtest results, they are not representative of exact trading conditions, it simply serves as a baseline for me to decide if a certain idea is worth exploring.
I first had this idea after trading the OEX weekly. I wanted to duplicate the concept of a weekly trading strategy that was not necessarily dependent upon having an underlying with weekly expiration contracts. So I thought about this question for a few days and the answer came one night in a blast of inspiration. Such inspiration was so strong I’ve decided to test it.
My first test was simple: enter a bearish position, if it goes against you, get out, use a short stop (-8%) for exit, and take profits as soon as you make over 8% in ROI. Exit by end of week regardless. So, I tested this for a bit over 1 year, then I listened to a few Sheridan Mentoring sessions where they were talking about a similar concept (yet monthly), the “chain of butterflies”, the key difference was that instead of exiting the trade, the strategy actually opens a new bullish butterfly if the market moves up. I thought hum, there might be something in there for me.. my weekly strategy could be improved...
So I tested again, this time by hedging the position with a single long if down by around 8%, and opening a bullish butterfly at the top. A lot of improvement on the data-set I had tested.
For the past 2 weeks I had the experience with live trading, as it turns out, my recovery butterfly (the bullish one) ended up hurting both times when I needed them. So I started wondering if simply hedging wouldn’t be better. But I do not allow myself to change a strategy before first testing it.. Lesson learned: do not jump from strategy to strategy based on one bad trade, test the new concept, is it indeed better? Or was it an isolated scenario?
Turns out, the best approach is still to hedge and add a second position to recover. I also learned trading live that using butterflies is a pain (they’re hard to get out) so I re-tested with Iron Butterflies instead, the difference isn’t major from testing results, but it is major (in my mind) in Live trading.
So, as you can see on the table, I’ve placed my results side-by-side, and you’ll notice that even though the hedge+recover strategy gives you a smaller average win, and worse win-loss ratio, it bumps your win-ratio a LOT. That more than makes up for it! One final disclaimer, this is based in only 1 year of data (last year), so take with a grain of salt as well. I will not backtest further until I have a better software program in my hands for backtesting..
Cheers!
4 comments:
Hi Gustavo,
You say "the best approach is still to hedge and add a second position to recover". Am I correct in saying then that the hedge is adding a single long put or call in the next month out then add a second Butterfly to gain more Theta?
Cheers
DZ
Hi DZ, yes you are correct, the hedge is adding 2x long call contracts to even ou the deltas.
I.e. Say the butterfly is down -50 delta, then I tested by buying 2x long calls with about 25, 26 delta each, getting to a position that is slightly bullish (say +3 to 5 delta), and then adding the second butterfly to bring in theta.
Like I said on the disclaimers, that's what the backtest shows, but then again, theory (backtest) and practice (live trading) could be different from each other by quite a bit..
Gustavo
Hi Gustavo,
thanks. Just a question, why add 2 long Calls with about 25, 26 delta each, why not just 1 with a 51 Delta?
Cheers
DZ
Aha, good question, I like it!
There are a few reasons why I've opted for going with 2x smaller delta hedges vs. 1x bigger hedge:
First is the Flexibility. Say the market starts to go back down, by having 2 contracts I can sell them back in phases, one at a time. If you have one big contract you have to wait longer before you can sell it to balance your deltas again. In this example, if I start to go back down and my deltas are now -25, I can dump only one of the long calls. This will happen sooner than the -50 delta, you'll be losing much more money if you let your delta go from 0 to -50 vs. from 0 to -25.
Second: By having 2x contracts instead of one, I give up a bit more theta, but gain more vega and gamma hedge. 2x contracts will therefore hedge the position better for the short term. In the long run, they will lose their power faster (because they're further away from the money), but since I want to use them for less than 2 weeks, I preffer to have the extra vega and gamma protection.
Play with both options in your TOS risk graph and you'll see the differences.
Hope that helps!
Gustavo
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