Short-Term Performance of Long-Term Strategies

It’s well documented that investors not only chase performance, ultimately yielding sub-par performance in pursuit, but they also do not have enough patience to stick with strategies long enough. My hope is that it ends today. You should objectively look at strategies for what their expected outcome range is, not what it’s done recently.

Kirk Du Plessis

Oct 15, 2020

Today we talk about the short-term performance of long-term strategies. To do this, we will be unpacking three different back-tested strategies from the new back-testing software and comparing outcomes, and chalking up the lessons these teach us.

Ultimately, we will see how a combination of methods can serve you best over an extended period, rather than a committed stance through the market’s ups and downs.

Realistic Expectations:

There seems to be an abundance of unrealistic performance expectations from investors. Even after a crash, hopeful ideas about short-term returns abound. These exist for many reasons; however, it would be beneficial for us all to return to more stable grounds.
This means keeping a longer-term vision in mind with more focus on data and a closer association with what suits one’s particular criteria and basing actions on that.
Investors need to be able to exercise some self-restraint and not ‘eat the cookie’ immediately. We all have to put up with some feelings of treading water because the narrative around the extreme highs and lows of trading can be very damaging to an investor’s psychology.
In the end, an individual’s perspectives and goals should determine their strategy and how they implement it going forward.

Introducing the Three Strategies:

The three strategies we are looking at today are in no way exhaustive and are just a few out of hundreds that prove a point in a certain way. They all prove together that any strategy can do very well or very badly in a small window of time.
The underlying message here is to be able to shift perspectives a bit and look at things with slightly longer time horizons. This means a broader look at metrics beyond merely the start and end date and the value at those points.
Each investor has different concerns and intended outcomes, this leads to certain metrics being more important than others, and there are ups and downs with each. After the 13 years in question from 2007 until 2020, what are the lessons we can take forward to improve our performance?

First Strategy — Long Call with SPY Monthly:

During the period in question, this long call strategy did very well. That is the broad view, and when we look at it in smaller sections, it can teach us something really valuable about how a portfolio curve can change over time.
There are important metrics to keep track of and consider when running this sort of test–return on capital, profit factor, the maximum drawdowns, etc. Depending on which of these you focus on, your focus can determine the success of your outcomes.

We see that this long call spread in SPY, entered every month, buying a call with a 30 delta, selling a call with a 5 delta, using 10% of your account, exiting at a 50% profit target, had excellent runs from 2010 to 2014 and again after 2016 running up to the current moment. The overall return on capital on this strategy over the period tested was 390%, an annualized CAGR of 12.6%. These high-performance periods were weighed down by its drawdowns in 2007 and 2008, its decline in 2014 to 2016, and the slow re-emergence after those drawdowns. This strategy’s maximum drawdown was about 70%; a significant amount of its performance was generated in the last year.
Therefore, we can see that this kind of strategy works really well when the markets are going up, but the downside does a lot to cancel that out. For the most part, this path should prove to have too many ups and downs to suit investment in the long-term.

Second Strategy — Iron Condor in IWM:

This strategy shows a completely different perspective on how you can build out a trading strategy and how you could start using it in auto-trading in the future. Like the first strategy, it is not always going to work, but is a great example of the variability of performance in different time periods.
A big takeaway that is underlined, here again, is that a short span of time can show you almost any results, and not offer a good reflection of long-term expectations. For this strategy, we entered a position every week and did nothing else.

For this strategy, an iron condor/iron butterfly was entered each week in IWM, 60 days to expiration, with short deltas of 50 and long delta of 5, essentially a straddle synthetic, and closed the position two days before expiration.
Compared with the long call strategy, this option had a much more stable distribution for the majority of the time, only declining notably in the last two years. There were long periods of high performance, with a few hiccups along the way. It was after 2017 that this strategy began to perform very poorly.
This adds a lot of context to the discussion and emphasizes the ups and downs we saw in the first strategy we looked at.

Third Strategy — Short Call on SPY

This option proves in many cases that the strategy itself can be very detrimental to a portfolio if the allocation is totally backward. Notice how different allocation amounts produce wildly different performance results.
A short call option was sold on SPY every week as long as there was room given the allocation constraints, with 60 days to expiration, at the 15 delta, and nothing else was done. No IV rank, no profit-taking, no stop loss was used. Surprisingly it did not fail as completely as might have been expected, and there were certain scenarios in which it worked pretty well.

From mid-2007 through 2011, this strategy did very well during this time of high volatility and market ups and downs. Then, if the allocation was too high, it had an incredible drawdown. However, the max drawdown on the 5% allocation had a max drawdown of only 2.5%. The test results from this strategy show us how performance can vary wildly across different allocations and at different times.

The Next Evolution:

The question that arises from this test is, how do we run these strategies together? That is where the next evolution is heading, using the strengths of each approach in combination with the others.
Investors seem to spend so much time in the mundane weeds of the system. If we can just elevate ourselves to a slightly new standard, using time more productively and doing the thinking that our minds are best at, we may be able to utilize all this learned information.
This ties into the increasing benefits of auto-trading and the more we can offload to automation, the more we can use our brains for the important parts to improve our performance.

Final Remarks on a Common Mistake:

A lot of people assume that the market always goes up over a given period of time. The third strategy test from today shows us how the S&P acted through 13 years of stable performance. Most people probably would not have believed the performance of the short call strategy to be true.
We need to be less short-sighted and view strategies and how we run them with the longer term in mind, with more patience, data, and self-restraint.

Option Trader Q&A w/ Steve

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Steve:

Hello, Kirk. This is Steve and I have been a long-term listener of your podcast and subscriber. I had a question for you regarding iron condors in an IRA. Now, I have a larger IRA and I know you had a podcast a while back on larger accounts, where you talked about using leaps for synthetic stock. This question is kind of along those lines. The question is in a normal iron condor, when you go with your long wings, again, in an IRA, in a larger IRA, those wings are very wide in my case. I’m essentially doing synthetic straddle, or excuse me, strangles and straddles, so again, those wings are very, very wide.

My question is also, is there benefit into buying those wings maybe a year out as a leap and then just trade my straddles and strangles within that on a monthly basis? I am trading the same underlines, usually higher volatility ETFs on a regular basis. Again, the thought process is to avoid the theta decay that occurs on those long wings by buying them over a much longer period of time and having the decay be less and then trade the straddles and strangles within that through the course of the year. If you could, please address whether or not you’ve ever looked at that concept. I’m certainly assuming you have. And whether or not it’s something that I should consider implementing in my trading strategy. Thank you.

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