The only point of taking more risk is to make more money.
I love “trading”, but it’s expensive in both time and transaction costs, and creates as many ways for things to go wrong as it does right. “Keep calm and SPY on” is good advice.
It’s hard to deny the thrill of a transaction though. Gaming the spread, fishing mid-market for someone to bite on your cheeky bid - that’s fun. While there’s the pain of whiffing when you get just a little too cute, there’s also a disproportionate amount of pride that comes from saving a few pennies.
It’s kind of like speeding - an analogy I made several weeks ago when talking about using leverage. There’s a thrill from moving just a little too fast. I suspect most drivers are doing it for that reason, as the marginal time savings are exponentially and inversely proportional to distance. (You can save meaningful time over long journeys, but no matter how fast you go locally the stop signs and other road hazards are just too impactful for the math to work.)
With risk in financial markets, there’s even less of a reason to enjoy it for its own sake. Have fun in the play account, YOLO some DOGE, that’s fine. But when you want to turn up the heat on serious investments, you have to look carefully at what you’re getting, and what it’s going to cost you.
The leverage example focused on the high level of a strategy that creates synthetic long stock using a risk reversal. By selling a put and buying a call - both struck at 15 deltas - you have the same exposure as 30 shares of stock. The delta replaces your equity exposure, but also comes with an additional premium.
Short OTM puts and long OTM calls gives you exposure to the skew risk premium. Puts are priced over calls at the same delta because of the spot:vol correlation, and higher expected volatility as stocks move down. Rather than just being long the equity risk premium via 30 shares of stock, short kurtosis adds a dimension of volatility risk premium.
As we detailed in Speeding on Leverage, there are a number of mechanics to this trade. We must rebalance deltas if there’s a sharp move, but also as time passes. There’s at least a trade every week to adjust, and sometimes additional delta hedges in between. Beyond just the downside risk, there are a lot of transactions and transaction costs.
This week in Backtest Notebooks, we’ll review the results of this strategy, and ask the question - is it worth it?
I’ll cut right to the alpha - yes it’s likely to improve performance on your account, but if you value your time with any meaningful premium, it’s a push at best. And trading through the downs is painful, and likely to shake all but the strongest hands.
I followed the basic strategy outlined in Speeding on Leverage. TLDR; Set a 30 day, 30 delta risk reversal (short put, long call), hedge daily at +/- 10 delta with stock, and rebalance weekly to new 15 delta strikes within the expiration. When DTE is < 5, roll out to a new 30 day expiration.
If you go back to 2009, there’s a lot of trading that happens. 222 monthly resets. 281 delta hedges. 783 Friday rebalances.
Over the long run, these spreads are EXPENSIVE. Even if you assume all your transactions are free, you’re paying a lot in spread width - almost $5k in crossing markets over the course for a one lot. That’s 30% of your gross Pnl.
But, they’re getting better. There are outliers like 2020 where wider markets during the initial pandemic crash raised the cost, but we’re very much trending in the right direction overall. 2025 however has been tracking expensive.
There are some assumptions here about how you’re going to get executed in reality. There isn’t much room for price improvement in SPY, but across two or even four legs it might be able to do a penny better then the net spread. Improvements in execution are more likely to come from trading in size and scaling in or out of positions.
However, execution cost isn’t the only thing that’s getting better - returns from the strategy have improved. The last five years have tracked significantly better than the previous 15 years combined.
The benchmark here is 30 shares of SPY, because you’re replicating 30 deltas. It’s not even close since the start of 2009 - SPY and hold is up 546% and the risk reversal strategy is only up 256%.
However if we compare the returns of the past 5 years, the strategy is up 115% versus 85% for the 30 delta portfolio. Annualized volatility of returns is 25% vs. 20%. A decade back (2015-present) the difference is a push, with total returns of 196% vs 192%. The strategy has 1.5% points higher annualized volatility at 18.9%.
Making generalizations about market environments, this strategy tends to do well during low volatility trends. Downward movement hurts more, but you get even more leverage on the upside. Markets that chop sideways (e.g. 2011 or 2015) can really cut up the strategy. Weekly trading means you’re going to get caught buying high and selling low regularly.
If we plot the realized volatility of the stock only portfolio against the strategy returns, we see this dynamic.
When comparing this to the returns of the regular stock portfolio, it highlights the extremes that are realized in this leveraged portfolio. It takes a few big winner years to make up for the negative compounding on the downside.
While there is some of the same relationship between returns and realized volatility, it’s nowhere near as stark.
The impact of trading regularly shows up in several places here. Spread costs from regularly transacting - even on penny wide markets - are a material part of your results. While these are improving, there’s only so much room to maneuver in SPY, and tight markets are approaching their dollar price savings asymptote.
From an options and greek perspective, the short volatility premium and gamma aspects ring true in the backtested results. When markets are trending upwards and realized vol is low, is when you can expect to collect the risk reversal premium. However due to the short gamma effect from exploding deltas on the downside, your worst cases are enough worse to dig a hole.
A further enemy of compounding is the chop effect in sideways markets. Where holding shares lets you ride the waves, constant trading locks in losses.
Practically managing this strategy is meaningful when you can automate it. There is significant room to improve execution, and reduce the time management aspect.