Today is the tenth trading day of the month.
We’re nearly halfway through January, and that means it’s time to check back in on SPY and TLT. Last month we dug into a trade where we monitor the relationship between these two and go long the laggard in expectation of a rebalancing.
Month to date (year to date) returns are nearly neck and neck, so it will be interesting to see how this evolves over the next few days. In the prior edition we found the 14th or 15th trading day was the best timing for entry.
Today we’ll explore another dimension of this trade. If we have a decent signal, the next question is trade setup. One problem is that options leave you with many….choices.
The number of strikes and expirations is a boon for anyone who is trying to put on a specific position. Combine this with the rich liquidity in top tier products, and you can put on almost any trade you want, at a price that’s very close to fair value.
The flip side of this is something like the paradox of choice. Too many different options can lead to decision paralysis. Trade selection becomes more ambiguous as we attempt to parse the difference between a 14 and 16 delta option.
When studying trade setups and how they performed in the past, it also introduces a number of specific pitfalls. We’ve talked before about how the texture of expiration listings has changed significantly over time, and how generalized advice like “take the next expiration on the left” means very different things over time.
To control for this requires some balance of qualitative and quantitative analysis. If you know spreads are more likely to reflect 2025 levels than 2009 levels, there’s some adjustment you could include with execution quality numbers. But every new knob, lever, and adjustment increases complexity. And complexity is a canard.
Our initial survey validated the signal, and spent time analyzing the sizing on the trade. Both are core components to any setup. Today in the Backtest Notebooks, we’ll play around with adjustments to delta and expiration.
Key Takeaways:
When selling put spreads, further out of the money returns less - except in bear markets.
A slightly longer trade horizon is preferable
Higher delta trades mean higher volatility of returns
