Updated Option Model: Enhanced and Debugged - Part 2

We just did an update to the Option model. This new version has flipped to red today. The action of the previous version of this model in the last 2 days made me realize that although this was the optimal result, the model was missing some of the most important trades. The option model itself (the blue line) was not the guilty one, and in fact, we didn’t change anything about it; the issue was the strategy built around it. You see, in the explanation about the model I gave, I said that the strategy was using some offset around the slow line to prevent it from flip-flopping when around the threshold. This means that for selling, the fast line needed to cross the slow line and go a little bit further, and on the way up, it had to go back over the same line plus another extra distance. This is what we call hysteresis, and it’s the lowest hanging fruit in terms of hit rate when using an EMA crossing strategy. I also said that we added a threshold that was a function of how far in terms of standard deviation we were from the 3-month SMA. This was to prevent flipping to red when in fact the model was very low, as correction there is usually not major. This was the guilty part of the strategy. Although this helped to boost the return a tiny bit, such a strategy was preventing the model from flipping to red in some important cases, particularly at around a meaningful top. Here are two examples:

So you see, the Option model accurately anticipated the drop in both cases, and having allowed it to flip to red would have resulted in two wonderful trades at the best possible moment. However, because the Option model tends to make lower highs as we start to approach a meaningful top, this activated the 'filter' that prevented it from flipping to red if we were significantly below the 3-month SMA.

Returning to the present time, although it looked like the lines had crossed yesterday, the hysteresis component prevented it, but this was expected. That being said, when I noticed that it didn't flip this morning despite its new lower reading, I realized the issue.

I immediately returned to our optimization framework that we built outside of TradingView and lowered considerably this filter that was creating issue. Six hours of simulation later, the 10 cores of my computer are exhausted, but I have found a new optimum that I am really pleased with. Not only is the return ratio in a very stable 'plateau' that also coincides with a very good stable hit rate.

 But it actually increased the return ratio, lowered the number of trades a tiny bit, and increased the hit rate to 74.3%, while now accurately flagging the October 2021 correction and January 2022 top. Here are the new stats:

Conclusion

Despite the fact that the previous version was using a strategy that was yielding very good results, I should have spent more time analyzing the actual trades of the strategy.

No matter what the stats say, there are points in the market that we don’t want to miss, and not triggering during the correction at the end of the 2020-2021 bull market was a point it should have raise a bearish flag. The option model didn’t miss it, as the image above shows, but the strategy built around it did. The new version is fixing that specific part.

I just implemented it in TradingView and uploaded it to supersede the previous version. As usual, when I upload a new version, you may have to restart TradingView. This new version should display WU SP500 Option Model [1.2]:

You will also notice some visual changes. There is now a constant thick line that changes color. This thick line represent the hysteresis zone. The model will flip to red when the actual Option model (blue line) drops below the lower side of that thick line. It will flip back to green when the fast line goes back over the upper side of the thick line. The default mode doesn’t show that line as it was making the overall result confusing, and it will be only useful when the blue line is about to cross. However, it can be activated in the parameter box by clicking 'Display Fast Line'.