Take the first expiration on the left

Backtest Notebooks

The outlines of a study come together like driving directions.

The first pass is something like “take the first left after the red barn.” Rolling down country roads that works well. The barn is obvious and there aren’t that many other left turn choices.

Maybe the shade of Rockwood Red isn’t exactly your definition of Barn Red, but it’s roughly the correct place. And that left turn is more of a bend in the road.

As the turns multiply, or the terrain gets more complex, there is an increasing need for specificity. Edge cases abound. If you’re giving instructions, you have to be aware of where there might be bumps in the road. A human can say “well obviously that’s the turn”, but it’s a little more difficult for a computer.

This is like when we’re trading live, and we have the benefit of being able to look at the context of the markets. Not just where things are pricing, but what strikes and expirations are available. With a little experience converting an objective into an actual strike selection becomes more intuitive. Backtests need to preempt all that other context with logic.

If the rule of thumb is to pick a strike that’s 20% out of the money, you’re likely to shift that if the strikes are “no bid” or worthless. You’d pull it up to a place that was more meaningful. When picking expirations you’ll bend the rules so that your position is spaced out instead of having an end of month position riding on top of a regular serial expiration.

Part of successfully managing options strategies is making these decisions on the fly. Implementation shortfall is one of the best ways to improve the results of a strategy. This concept is typically applied to order execution, but we can use it more generally to encompass the dozens of tiny decisions that are made as we put theory into practice.

Good execution recognizes the market dynamics and adjusts order entry in response. If offers are getting lifted and price is going up, now isn’t the time to get cute on the bid - nibble a little more aggressively. Knowing when to float them and when to lift them is enough to turn a scratch strategy into a winning hand.

But before it’s time to trade, you need to pick what series you’re targeting. That’s not quite as straightforward as it sounds.

As liquidity improves, and the count of strike choices explodes, this becomes less and less of a problem in the top tier issues. Today SPX and SPY are wrapped in a chainmail of series - anywhere you poke there’s coverage. But it wasn’t all that long ago that these listings looked more like Swiss cheese. And plenty of other tickers look like that today.

To better prepare yourself for making these tactical adjustment decisions, it’s helpful to study what did and didn’t work in the past. If you put in a simple set of rules, when the data isn’t robust enough you’ll get some silly outputs.

Today in the Backtest Notebooks, we’ll explore the implications of expiration selection. What kind of rules can we implement to make our study more adaptive, and how much does it matter?