A Basket of GULLs

The Backtest Notebooks

I’d like to welcome all my loyal readers to 2025 with a new content theme in Portfolio Design.

The Backtest Notebooks will be a discussion about how to design, build, and evaluate the results of options backtests. For our longer term strategies, this is an incredibly helpful tool to set risk and return expectations.

Past performance might not be an indicator of future results, and there are plenty of traps with over-optimization, but the context and data provided by backtests are invaluable. The texture of a strategy is revealed by tracing it through history according to specific parameters.

It’s not just the count of strikes and expiries that make options backtesting more complex. While it's easy to say sell a call in AAPL every month, how do you pick the strike and expiry if there isn’t a perfect match? Are there any indicators that suggest not selling the call? Or selling twice as many?

A backtest is the opposite of a discretionary system. Every trade is done by rules, not a gut feeling about what percent out of the money to roll. You have to be able to codify all of those rules and think about the corner cases.

That’s what makes the hedged equity structure the perfect place to start. The most systematic of options strategies, with the GULL trade you are exchanging one convexity for the other. Limiting both upside and downside for $0 cost.

Implied volatility levels will change the payouts of this structure, and we’ll foreshadow adjustments you can make based on that later on. But systematically applying a put spread collar overlay is the one option trade I’ll let you do without any opinion on whether options are cheap or expensive.

As a refresher, the GULL buys an out of the money put spread on the underlying stock, and funds that protection by selling the furthest out of the money call which offsets the debit. It’s typically done quarterly, and for the SPX the most common protection level is 5%/20%. This gives roughly 5-6% upside in call space.

With indicators we can track the price of that structure every day, but we need a backtest to know how much your account value changes. And also importantly how your account value changes relative to the benchmark.

The lure of hedged equity is borne out by our example backtest. With a portfolio split between SPY and QQQ, over the last 7 calendar years, the GULL realizes roughly 73% of the returns, with only 57% of the volatility.

Today in Backtest Notebooks, we’ll step through the decisions and design choices for a multi stock GULL portfolio. And it’s all outside the paywall! If you like what you see, please consider subscribing for both this and Fifty Ways to Trade an Option.

The SPY and QQQ ETFs are good starting points for a multi-portfolio test. There are many fundamental reasons to own either of these as large allocations, and the resulting options liquidity is very deep. But that doesn’t leave it free of many trading decisions that might subtly shift your outcome.

The basic hypothesis: Split your equity between SPY and QQQ, then trade a tranched 3 month GULL structure, rolling every month.

When you start by splitting up your theoretical $1,000,000 (or $10M or $100M), the first question is how much leftover to keep. Whether it’s to pay account fees or just have a cash buffer, you might not want to allocate every last penny. Here we started with 2%.

I then made the decision to only trade round lots. This leaves more cash on the sidelines, but also means the position is completely “hedged”. (Maybe you only want 50% hedged anyways?)

Dividend reinvestment sounds interesting because hopefully your longs keep going up. However for the GULL structure these past years, you need far more cash than dividends to buy in the short call.

Selling stock is a practical option, and this could even be automatic through assignment at expiration. But now with a higher stock price, your share count will be adjusted lower, and you’ve created a taxable event that could be punitive or sub-optimal. Even just over the weekend stock could move even further away.

You can simply allow the cash balance to go negative. (I did.) Most brokers cleanly let you borrow cash against securities, but interest might add up. In the real world, you’re ideally adding funds to a long term account on a regular basis. This would offset the borrowing demands, yet introduces another dimension of variables related to frequency, sizing, and basis.

The other cash injection that’s possible is from the put spread. In a down market, your hedge will be monetizable on expiration. Not as good as stock going up at exactly the right rate, but you are cash rich when stocks are on sale, and could use this to buy more equity. Unfortunately in this sample those dip buying situations never hit significantly enough to buy more round lots.

A backtest is just a science experiment - we know an actual brokerage account is messy and difficult to model, so pick which things are useful or reasonable to control for.

With some broad cash management rules in place, it comes time to make the options trades. The first rub for a tranched position is how to initiate. Do you set up all three at once, or let it happen naturally by consistently selling the 90 day expiration? In this test I set it all at once when the first monthly expiration comes up.

Practically speaking, there are good reasons for both. If poof money in the bank happens, I tend to err towards allocating all at once. You can’t pick your dips, so just go ahead and trade. When you’re reallocating a position, it can be psychologically easier to get an average price over a few different trades.

If you do it all at once, each month is going to have a very similar structure, because the downside is a hard target that was set based on a 90 day trade window. If you want to scale that back to be smaller for shorter periods, you’ll give yourself more upside. Something to do in the real world, not really a backtest.

Transaction costs and slippage are real variables though. The benchmark crowd only has to buy stock once at the beginning (or quarterly with dividends), but the options structure is trading 3 legs every month to open, and possibly closing either a short call or long put spread.

Thanks to our vibrant and customer friendly market structure, customers are often trading for free inside the bid/ask price. But SPX does have charges, and liquidity slips rather quickly if you’re looking at anything outside the very top.

Corporate actions are typically only a gotcha for individual equities, but even during this test period QQQ had a special dividend that adjusts the strikes. Not only do you have to pay yourself the dividend, but also adjust your theoretical position strikes for the next 3 months. Stock splits require changes to both strikes and position quantities.

After resolving all of these little questions, we have some pretty interesting numbers to parse. The strategy is going against some pretty high performers, particularly in recent years. Yet it manages to capture a significant part of the returns, with quite a bit lower drawdowns.

The above is the specific outcome of a variety of choices we made along the way. Some of them are for practical purposes, some of them are for ease. Ultimately its a model for how hedged equity buffers traditional strategies in different market scenarios. It’s certainly not financial advice.

The next questions here are endless. The way the GULL works on equities is different from indices, and requires some volatility adjustments. For a stock that is lower vol than QQQ, we perhaps don’t need as wide a put spread, or vice versa for a volatile name.

The percentage of a portfolio to overlay is another important consideration. Hedged equity isn’t a binary decision, it can be used to cover only parts of your holdings, or more and less at different times.

If you’d like to discuss more about these results, or backtesting in general, reach out below.