Theta Vault Backtest Results

Ribbon Finance is launching the first on-chain perpetual ETH weekly call-selling product, the Theta Vault. The vault aims to automate the process of selling call options, and compound the premiums to generate high yield on ETH. By depositing funds into this vault, users can save on gas fees and the complexities of rolling their own options strategy. For a more detailed overview of how the product works, read this post.

This post examines an example covered call strategy that we have come up with, and a backtest of how this strategy would have performed over the last year.

Strike Selection

Strike selection is one of the key pieces in the Theta Vault product because it represents a tradeoff between yield and risk. Selling a call option with a further strike will have lower risk of exercise, but lower premiums as well. To test various methodologies for strike selection, we collected option pricing data from Deribit from the beginning of 2020 until now, ran backtests on each method and measured which methods performed the best.

We tested two main methods for strike selection — Percentage Price from Current Price and Optimal Delta. Both methods were backtested on Deribit data from March 2020 to Feb 2021, when ETH ran up from $80 all the way to a $2k high.

  1. Percentage Price from Current Price

This method selects strike prices based on some percentage difference from the current price. For example, if we believe that it is unlikely for ETH to move >30% on average per week, we could sell call options whose strikes are 30% above the current spot price. Based on our backtests, 20% above the current price was the sweet spot of yield vs risk of exercise. This is how the strategy performed from March 2020 to March 2021:

USD Return: 1,330%
ETH Return: -13.7%
Total trades made: 60 trades (weekly)
Win rate: 93%
Average Weekly Return (ETH): -0.04%

Strategy performance in ETH terms
Strategy performance in USD terms

Although this strategy performed extremely well in USD terms, it still lost ~13.3% against a naive buy-and-hold ETH strategy. This is because most of the gains were erased in a single week, when ETH almost doubled in the first week of Jan — an absolutely parabolic move. Because the covered call strategy gives up potential upside, this week alone led to a fairly large drawdown in ETH terms, despite being up in USD.

2. Optimal Delta

Calculating strikes based on specific option delta is a more advanced method to select strikes, because they take into consideration how much the market expects the asset to move. Delta of an option is a measure of how much the option is expected to move in accordance with a $1 price change in the underlying.

In our backtest, we found the optimal delta to maximise weekly yield is to select deltas closest to 0.1d. This is how the strategy performed from March 2020 to March 2021:

USD Return: 1,840%
ETH Return: 18.7%
Total trades made: 60 trades
Win rate: 98.3%
Average Weekly Return (ETH): 0.6%

Strategy performance in ETH terms
Strategy performance in USD terms

Again, we can see that the strategy had a significant drawdown in the first week of January of 2021 when ETH almost doubled. However, using deltas to select strike prices has created a more reliable strategy, outperforming ETH by almost 20%, even when ETH appreciated 15x in USD terms. This gives us more confidence that a covered call strategy, designed right, can outperform ETH even in extremely bullish market conditions.

Conclusion

Covered call strategies work very well in a flat or down market, where risk of exercise is non-existent. However, we have seen here that, if constructed correctly, a covered call strategy can outperform buy-and-hold even in a bull market.

On the other hand, in down or flat markets, the strategy should perform well because the risk of exercise is low. We could not backtest this strategy from the 2018–2019 bear market because of how nascent the ETH options market was.

Given that backtest data is never a perfect reflection of reality, these strategies need to be tested against real market conditions to see how they hold up. There are various other concerns like liquidity, pricing, and transaction costs that will lead to a different outcome in production. This blog post is merely a glimpse of the return profile one could achieve from running a covered call strategy on ETH.

On the other hand, vaults can also run more sophisticated strategies over time such as more aggressive strike selection during flat markets or “stop losses” to prevent drawdowns when ETH pumps extremely hard. Given that these vaults will eventually become community-owned, we expect many talented managers from the community to iterate and improve on the example strategies we outlined above. If you have feedback or questions, we would love to discuss them in our Discord!

Huge thanks to Cindy Leow for helping us with data collection and backtests of various strategies. Follow her on Twitter here.

Disclaimer: The content of this post is provided for informational purposes only. Nothing herein constitutes investment, legal, or tax advice or recommendations. Nothing on this site should not be relied upon as a basis for making an investment decision. It should not be assumed that any investment in the asset class described herein will be profitable and there can be no assurance that future events and market factors would lead to results similar to any historical results described.

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