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Backtesting Options Spread Trading: Bull Call and Bear Put Spreads
Here, we will talk about the spread trading strategies. We will be focusing on two key strategies: the Bull Call Spread and the Bear Put Spread. These strategies are designed to navigate both bullish and bearish market scenarios while effectively managing risk. This strategy can be applied to all "European Type" options and we have a dedicated section in course which explains sourcing US options data.
All the concepts covered in this post are taken from the Quantra course on Systematic Options Trading. You can preview the concepts taught in this course by clicking on the free preview button and going to Section 23 and Unit 11 of the course.
Note: The links in this tutorial will be accessible only after logging into quantra.quantinsti.com
What is spread trading?
Spread trading is a strategy where you buy and sell related contracts at the same time to profit from price differences when you have a particular view on a stock's direction. Two common types are bull call spreads (expecting a stock to go up) and bear put spreads (anticipating a stock to go down). These strategies help manage risk while aiming for profits.
What is Bull Call Spread?
A bull call spread can be deployed when you have a bullish outlook on the underlying asset. This strategy involves buying one call option and simultaneously selling another call option on the same underlying asset but with different strike prices. The key components of a bull call spread include:
- Long Call Option: Purchasing an at-the-money (ATM) or slightly out-of-the-money (OTM) call option. This allows you to profit if the underlying asset's price rises.
- Short Call Option: Simultaneously, sell a call option with a higher strike price than the one you bought. The sale of the higher strike call option generates income, which helps offset the cost of the long call option.
Bull Call Spread
A bull call spread benefits from a moderate upward price movement in the underlying asset while simultaneously limiting the cost of establishing the bullish position. This strategy is deployed when there is an expectation that the asset will rise in price, but you want to reduce the upfront cost and risk compared to simply buying a single-call option.
Why should we go long on bull spread trading and not directly buy the call option?
When buying a call option to capture the bullish directional move, you end up paying a higher premium for unlimited upside benefit. But generally, stocks don't move that much in a short period of time. So, you are better off letting go of some upside and reducing the premium upfront by buying the spreads. There are other pros and cons also involving greeks, which is out of the scope for this Quantra classroom.
What is Bear Put Spread?
A bear put spread can be used when you have a bearish outlook on an underlying asset. It involves buying one put option while selling another put option on the same underlying asset, both with different strike prices. The key components of a bear put spread include:
- Long Put Option: Purchasing an at-the-money (ATM) or slightly in-the-money (ITM) put option. This allows you to profit if the underlying asset's price decreases.
- Short Put Option: Simultaneously, sell a put option with a lower strike price than the one you bought. The sale of the lower strike put option generates income, which helps offset the cost of the long put option.
Bear Put Spread
The primary objective of a bear put spread is to benefit from a moderate downward price movement in the underlying asset while reducing the upfront cost and risk associated with establishing a bearish position. This strategy is useful when you expect the asset's price to decline but want to control the cost and limit potential losses compared to solely buying a single put option.
One of the efficient ways to do spread trading is through systematic options trading.
Why trade options systematically?
Systematic options trading involves applying predefined strategies and rules consistently, offering several advantages. It enables disciplined decision-making and reduces emotional trading, which can lead to impulsive and costly errors. Also, when trading systematically, the strategies can be automated, allowing better market monitoring and execution, even when you are not actively engaged. It also offers scalability, as systematic models can handle large volumes of trades efficiently. Overall, trading options systematically enhance the consistency, risk management, and scalability of the strategies.
What are the Entry and Exit Rules?
Let’s create a long-short spread trading strategy which deploys a bull call or a bear put spread based on the bullish/bearish signals generated using indicators. The strategy can be as follows:
- Entry:
- If the 20-period simple moving average (SMA) is greater than the 50-period SMA and the ADX value is greater than 20, then we will generate a signal as 1.
- If the 20-period SMA is less than the 50-period SMA and the ADX value is greater than 20, then we will generate a signal as -1.
- Exit:
- We will exit the trade if the take-profit or stop-loss levels are hit.
- The other condition for exit can be the difference in the value of the signal and current position. For example, if the current position is 1 and the signal is -1, we will exit the position.
In the above strategy, we have used the moving average to identify the direction of the trend and ADX indicator to determine the strength of the trend.
Note: The indicator values such as 20-SMA and 50-SMA crossover and ADX values greater than 20 are taken for illustration purposes only. You can modify the same as per your strategy.
It is important to backtest this strategy so that we can know the effectiveness of this trading strategy.
How to backtest this strategy?
You can apply options backtesting to the above strategy in Python. You can calculate the indicator values and use them to generate entry and exit signals. Finally, you can backtest the strategy on historical data based on the generated signals and check its performance.
Performance Plot
It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.
The strategy discussed above has been covered in detail along with the Python code in this unit of the Systematic Options Trading course. You need to take a Free Preview of the course by clicking on the green-coloured Free Preview button on the right corner of the screen next to the FAQs tab and go to Section 23 and Unit 11 of the course.
What to do next?
- Go to this course
- Click on
- Go through 10-15% of course content
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IMPORTANT DISCLAIMER: This post is for educational purposes only and is not a solicitation or recommendation to buy or sell any securities. Investing in financial markets involves risks and you should seek the advice of a licensed financial advisor before making any investment decisions. Your investment decisions are solely your responsibility. The information provided is based on publicly available data and our own analysis, and we do not guarantee its accuracy or completeness. By no means is this communication sent as the licensed equity analysts or financial advisors and it should not be construed as professional advice or a recommendation to buy or sell any securities or any other kind of asset.
