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ANALYTICAL TOOLBOX: Platinum Backtest Tools, IV Model


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Clare White, Optionetics.com
April 19, 2007

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Newly employed combination strategies can be backtested via the Platinum Greek Model discussed last week or via the Implied Volatility [IV] Model. This second model may provide insight that is less intuitive than greeks are to the experienced trader. As a result, the learning curve for the new strategy may be accelerated.

Strategy Set-Up & Scan

A call calendar spread that appropriately addresses risk is established by selling a shorter term call option and buying a longer term call option. Risk is appropriate because the short call is protected by the long call through its expiration. When the strategy uses different strike prices, the call calendar represents a diagonal spread.

An ideal calendar scenario exists when there is an IV skew for the calendar pair. That is, the short term IV is higher than the longer term IV.  This may occur when the near month option is at-the-money [ATM] or near the money and the longer term option is in-the-money [ITM]. Such a combination can be evaluated with the Covered Call trade finder along with other Platinum tools.

On a monthly basis, a scan is completed on the Monday following expiration searching for IV skews that include near month call options for the short position and further out options for the long position. The top two positive skews with a minimum Probability of Profit value are traded, if these two criteria, along with others are met. This system is part of the OASIS Trading with Probability Curve topic and will be further outlined there. The calendar spread is closed on the last trading day before the short expiration by buying back the short position and selling the long position.

Backtest Using the Greek Model

The calendar scans described were backtested over two periods; a bearish period from Jul 2000 to Jun 2002 and a bullish period from Jan 2005 Dec 2006. The first trade from each period is used here to display the greeks over the course of the trade.

The first calendar established was an Amazon (AMZN) Aug-Jan 40-35 spread on the Monday following Jun 00 expiration. AMZN closed at $38.75, so the 40 strike short call with approximately 1 month to expiration was near the money while the 35 strike long call with approximately 6 months to expiration was ITM. The IV skew was +11.86 with IV levels higher for the short position that would experience quicker time decay ([selling the higher IV).

Figure 1 displays the backtest Greek Model from trade initiation to expiration of the short option. Since closing values are used, there is a significant change in greek values when the short leg expires worthless (highlighted, with a close for AMZN at 39.00). Net IV and the skew increases the first two days the trade was in place, then net IV oscillates between 169 and 194.  

Figure 1: Platinum Greek Model for AMZN Calendar Trade Initiated Jul 24-2000
(Click here for larger view.)

Although the IV skew served as a basis for the trade, the trader new to such a position will gain more information from the Delta and Theta columns. Note the values from Jul 28th through Aug 1st for price, delta and theta. A $0.13 rise in price holds losses steady over the weekend [net change to position = 0], but the following day a $0.12 rise improves the position by $19.


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