Options Trade

Evaluation Case
Study

Background
IOTA Technologies is launching the Systematic Edge Derivatives Fund, a hedge fund, and has
been investigating candidate options trading strategies. Recently, Andrew Falde, a professional
options trader affiliated with SMB Capital, recommended the factorial analysis of a weekly
butterfly trade, the Road Trip, developed by well-known trader Dan Harveyi, which IOTA has
undertaken. This document presents findings to date with two objectives, to share 1)
recommendations for configuration of this trade and 2) one hedge funds approach to selecting
and evaluating option trades.

This document reports interim results of an on-going study, as discussed below.

IOTA and SEDF

As its name implies, SEDF applies a systematic, that is rules-based, approach to options
trading and has developed a proprietary methodology for evaluating and optimizing options
strategies.
This methodology comprises the following elements:

Programmatic (automated) options backtesting with IOTAs QuantyCarlo toolsetii.

Factorial Analysisiii to identify important trade parameters and associated values to
improve trading performance
Inferential statistics coupled with predictive analytics to model and optimize trading
results and predictive reliability of findings, while avoiding dangers of curve-fitting.

Applying the Methodology

To maximize the efficiency and utility of its options analysis methodology, IOTA has adopted a
standard set of practices and procedures for evaluating options strategy performance.

All testing and optimization results are measured with a mathematically-based Desirability
Index (DI)iv. This is crucial for comparing and selecting strategies. This proprietary index
includes four metrics: win rate, ratio of average trade win to average loss, statistically-
determined probability of positive average return and annual return on investment.

Evaluation proceeds as follows:

1. Using QuantyCarlo, first define and test the baseline strategy as defined in the
developers trading plan. This baseline is crucial to evaluating possible trade
improvements that will emerge from application of the methodology.
2. Develop a set of factorial combinations for trade parameters, such as entry days to
expiration, placement of position legs or maximum loss limits, and evaluate their impact
on trade performance, as measured by the IOTA DI. At this stage, adjustments, if any,
are not studied; the goal is to first determine how well the trade can perform without
them.
3. Model and optimize the trade, resulting in the identification of a combination, that is, a
set of parameter values, that delivers statistically-superior performance, again as
measured by the DI.
4. Compare the results to date with other current and candidate strategies to determine if
this candidate bears further investigation. If so, and if the original trading plan included
adjustments, these may be evaluated with the above procedure. The goal will be to

2 David L. Wilt, IOTA Technologies, Jan 2016

 determine if the adjustments deliver statistically superior results; if not, there is no
justification for incorporating them into the trading strategy.

Road Trip Trade Findings

The Road Trip trade, as defined by Dan Harvey, is an asymmetric (AKA broken-wing) put
butterfly using weekly SPX options. The complete trading plan provides instructions for entry,
exit and adjustment, but the latter were not evaluated. As Dan explains, the strategy was
designed to require modest, perhaps daily, attention and therefore could be traded even while
traveling.

Baseline Results
As discussed above, the first step in the IOTA evaluation process is to create a digital version
of the Road Trip trading plan baseline (without adjustments) in QuantyCarlo and then test it.
The tested trade configuration is shown in the table below. (See Appendix A for results
summary.)

Tested over 2014 and 2015, Road Trips IOTA Desirability Index value was 0.866, on a 0.0
1.0 scale. This is an excellent score and would likely quality this trade for SEDF consideration.
However, based on IOTAs experience with trade optimization, improved performance can be
achieved.

3 David L. Wilt, IOTA Technologies, Jan 2016

 ROAD TRIP BASELINE CONFIGURATION
SPX Put Butterfly, weekly options
Enter 70 to 75 DTE on a flat or down day
Upper long strike 10 points above current SPX price
Short strike 40 points below upper long strike
Lower long strike 50 points below short strike
Maximum cost: $1.25
Profit exit: 20% of margin
Loss exit: 30% of margin
Time exit: 14 DTE unless price 30 points above upper long strike
Optionally add far OTM long put (AKA teenie)

Factorial Analysis
Factorial Analysis (FA) is a well-established methodology for improving products and processes and has
been applied successfully in a wide range of settings, from agriculture to pharmaceuticals. Its basic
premise is simple: identify the parameters (AKA factors) that affect the product or process, in this case
options trading, specify an array of values for each, and then test each unique combination of those
values. Importantly, FA discovers not only the impact of each factor, but also their interactions, as
opposed to one-factor-at-a-time (OFAT) testing.

Given the number of factors in the Road Trip plan, a series of FA studies were undertaken. The table
below lists the factors and their respective values for one of the studies, as well as the value that was
associated with the best-performing combination. Note most of these are consistent with the baseline,
with two exceptions: higher dollar limit for butterfly debit and and target profit factor.

FACTOR VALUES BEST

Maximum days to expiration at entry 35/55/75 75
Maximum points ITM for upper long strike 0/5/10 10
Distance from upper strike to short strike 25/35/45 45
Distance from short strike to lower long strike 30/50/70 50
Maximum butterfly debit $1.25/2/3/4/5/6 $4.00
Days to expiration at exit 8/15/22 15
SPX price points above upper long strike to override DTE exit 10/30/50 30
Max loss for exit as percentage of margin 0.2/0.4/0.6 0.6
Target profit for exit as percentage of margin 0.1/0.25/0.4 0.25

4 David L. Wilt, IOTA Technologies, Jan 2016

FA Results
As expected, the factorial analysis yielded substantial improvements in trade performance, as
measured by the IOTA Desirability Index, as well as other selected metrics in the table below. The
growth in Annual Return on Investment is particularly compelling.

In addition, the analysis to date does not show any benefit from two of the rules included in the
baseline plan: 1) entering only on a down or flat day in terms of SPX price and 2) adding a far OTM put
(teenie) at entry.

METRIC RT BASELINE TOP

COMBINATION
Desirability 0.866 1.000
Total Profit $20,031 $44.196
Average Trade Return $953.86 $1,194.49
Return on Average Risk 14.45% 23.57%
Annual ROI 157% 452%
Number of Trades 21 37
Win Rate 71.43% 89.19%
Average Win/Average Loss 2.54 1.02

Next Steps
As mentioned above, this analysis is ongoing, and the findings should be treated as preliminary. The
next step is to optimize the factorial findings, which entails extensive testing of the results with out-of-
sample data to avoid possible curve-fitting and identify statistically superior factor values. Generally,
the combination(s) that result include factor values not appearing in the factorial testing, which allows
for further improvement in performance.

Based on the optimization results of the non-adjusted trade, adjustment rules as proposed in the
trading plan will be added to the QC plan and tested using the procedure above. IOTAs experience to
date indicates developing adjustment rules that reliably deliver statistically significant improved
performance is challenging, particularly if the non-adjusted strategy has been optimized.

IOTA will share the above results with SMB when they are available.

5 David L. Wilt, IOTA Technologies, Jan 2016

APPENDIX A. ROAD TRIP BASELINE RESULTS

6 David L. Wilt, IOTA Technologies, Jan 2016

i Dan has a long and distinguished history as a options trader, strategy designer and mentor.
ii Worlds first system for design and automated backtesting of options strategies.
www.QuantyCarlo.com
iii https://en.wikipedia.org/wiki/Factorial_experiment#Analysis
iv https://ideas.repec.org/p/zbw/sfb475/200443.html

7 David L. Wilt, IOTA Technologies, Jan 2016