Does Adding a "Trend Filter" Improve Directional Option Selling Strategies?

"The trend is your friend." It’s a popular saying amongst traders, and we hear it all the time. But is there validity in the statement?

We backtested directional option selling strategies with a long-term trend filter to see if there was a significant impact on performance.

We used Option Alpha's backtester to review the data for  SPY, GLD, and TLT short put spreads and short call spreads. Short put spreads included a filter to only enter trades above the 200-day moving average. Short call spreads included a filter to only enter trades below the 200-day moving average.

Backtest settings

We tested credit spreads with the same setup across three different tickers to standardize entry criteria. Each test used the following settings:

• Symbols: GLD, TLT, SPY
• $5,000 allocation
• 45 days until expiration
• 0.30 delta short strikes / 0.15 delta long strikes
• Sequential trade entry (no overlapping positions)
• 50% profit target
• Exit 1 day until expiration if profit not hit
• No stop loss

Each backtest has an ‘A’ version and a ‘B’ version.

‘A’ tests (green) had no filter; we entered positions regardless of the trend. ‘B’ tests (blue) utilized a trend filter: we only entered short put spread positions when the underlying symbol was above the 200-day moving average. Conversely, we only opened a short call spread if the underlying symbol was below the 200-day moving average.

SPY positions also included a third variation with an RSI filter to only open short put spreads if the 14-day RSI was below 70 and only open short call spreads if the 14-day RSI was above 30. This helped to filter out trades in overbought and oversold conditions that may be prone to a reversal.

Important Note: This podcast is for educational purposes only. Past performance does not guarantee future results. This data is presented objectively and is not financial advice or a suggestion to use these strategies. We encourage you to always do your due diligence and test your strategies.

GLD Short Put Spread

There was no significant difference between the two strategies although the strategy without a filter performed better in several areas.

While there weren't necessarily top-line capital improvements, there were smaller drawdowns and less overall volatility with the trend filter. The two strategies had a similar overall win rate, consistency metrics, and variance between max win and max loss.

Conclusion: The trend filter led to small improvements in some areas, but actually hurt performance overall.

GLD Short Call Spread

The version with the trend filter was slightly less profitable overall but also avoided the early drawdown because so few trades were entered in the first three years while GLD was above the 200-day moving average.

Conclusion: The trend filter didn't help improve performance, but did hold cash during a losing period.

TLT Short Put Spread

Trading TLT short put spreads above the 200-day moving average was clearly more successful than the strategy without the trend filter. Trend following improved the win rate and helped avoid many losing trades over the last two years when TLT was below its 200-day moving average and not in bullish trades.

Conclusion: The trend filter improved performance in almost all categories.

TLT Short Call Spread

Similar to the GLD short call spread, TLT’s trend filter neither hurt nor helped bearish positions. Again, simply not entering trades when above the 200-day moving average did help to avoid some significant drawdowns. Somewhat unsurprisingly, not trading also led to missing out on some large wins.

Conclusion: The trend filter hurt performance slightly, but no significant difference.

SPY Short Put Spread

While the performance of tests A and B were similar overall, adding a trend filter definitely helped avoid a large drawdown in last year’s bearish market. Using a trend filter led to more efficient and consistent returns. Without the filter, the strategy experienced multiple drawdowns.

Filtering for overbought RSI (14-day RSI above 70) improved performance in almost every category, and highlights how testing multiple indicators together can help optimize the strategy even more.

Conclusion: The trend filter helped, and RSI filtering was even more successful.

SPY Short Call Spread

There was a noticeable difference when using a trend filter on SPY short call spreads. When the filter was applied to the strategy, it prevented many trades that really hurt results. However, performance was much worse relative to the SPY short put spreads.

The RSI filter wasn’t as significant compared to the put spreads, but it did improve performance slightly overall and had smaller losses.

Conclusion: Trend filtering improved performance dramatically with fewer trades and much smaller drawdowns.

Summary

Short put spreads outperformed short call spreads in every ticker, and in some cases more so when applying a trend filter. We can conclude that there is some validity to trend following, specifically for short put spreads in TLT, and especially in both SPY strategy setups. The trend filter seemed to impact short call spreads less. 

The data suggests that trading with the trend filter can improve the performance of directional option selling strategies, but maybe not as much as we may have thought. In general, profits were not substantially higher, but avoiding trades did lead to fewer drawdowns and large losses.

It will be valuable to keep testing and exploring this idea, perhaps with different strategy setups, alternate trend filters, and additional technical indicators. We encourage you to backtest your ideas and share the results with the Community!

Automating trend-following option strategies

Tracking moving averages for one or more ticker symbols is not always possible for traders (let alone entering and managing the trades). Option Alpha makes it easier than ever to not only backtest your ideas, but turn them into automated trading strategies. You can create a bot from any backtest, or create your own custom strategies.

Here is a bot example to automate the backtested strategies discussed in this podcast. If you're not already an Option Alpha member, sign up here to start a 30-day free trial to backtest, create, and clone automated trading strategies.