Strategies that can demonstrate huge winning percentages through unbiased backtesting are extremely appealing. Imaging the streaks that you could run up if your system was winning on better than 80% of its trades!
Of course we all know that these types of strategies are almost always accompanied by the same tragic flaw: potential for catastrophic losses. That flaw makes these types of strategies great for video games and practice accounts, but not for trading our hard-earned capital. There is no reset button when you are trading real money.
These types of strategies are often referred to as “picking up pennies in front of a steamroller,” which provides a vivid mental image of the potential pitfalls. In a recent post, Dan from Theta Trend thought it would be an interesting case study to see how one of these “steamroller” strategies would have fared over the course of 2013.
Dan’s Accelerated pTheta Strategy
The strategy that Dan tested was a version of his pTheta strategy. Here is how he describes it:
The penny system sells out of the money vertical spreads in the $SPX every week using 10 delta weekly options with 8 days to expiration. Every Thursday the system sells a vertical spread.
If the market is closed on a Thursday (Thanksgiving), the strategy sells the verticle spread on the next day. Dan explains that his strategy uses the Parabolic SAR indicator as a trend filter to determine the direction of his trade:
If price is trading above the daily pSAR, the system sells put spreads below the market and call spreads are sold if price is trading below.
This gives us the basic outline of a simple options strategy that makes one trade every single week with a very high winning percentage.
Backtesting Dan’s Strategy
Over the course of 2013, Dan’s Accelerated pTheta Strategy would have made a total of 52 trade. Of those trades, 44 would have been profitable and 8 would have been losers. That works out to a win rate of 84.62%. 33 of the trades were on the long side, and the remaining 19 were on the short side.
The average winning trade returned a profit of 0.425%. The average losing trade cost the account 1.701%.
Dan tested two different positions sizes for the strategy. His 5% Max Loss version traded 2 spread and his 10% Max Loss version traded 5 spreads. The 5% Max Loss version returned 10.19% for the year with a maximum drawdown of 15.68%. The 10% Max Loss version returned 25.48% for the year with a maximum drawdown of 35.41%.
The Equity Curves
The equity curves Dan provides do a great job of illustrating the steamroller point. Both versions of the strategy were cruising right along when they were suddenly smacked with severe losses in early April. Dan explains that there were actually two huge losses in a row that month.
In order to explain how severe those losses were, Dan provides the returns for the year if those two trades weren’t made. In that case, the 5% Max Loss version would have returned 20.81% for the year with a 5.82% maximm drawdown. The 10% Max Loss version would have returned 52.03% for the year with a 13.14% maximum drawdown. Those returns sound great, but they are just wishful thinking because those two big losses actually did happen.
Dan explains that the major flaw with strategies like this is that when things get bad, they do so in a hurry. It is also a concern that the very low point of the equity curve is exactly where most traders would give up on the strategy. If you started trading the 10% Max Loss version with $10,000 in January of 2013, after the two big losses in April you would be left with less than $8,000. Would you have the courage to keep trading?