Originally published on Medium
Is Options Backtesting Useful?
Some traders question the validity of backtesting as a useful tool. They argue that: “Options trade strategies cannot be reliably back tested. Studies can be performed to develop strategies but the only test applicable is real time with real money. “(1)
Given that a backtest is a empirical exercise it is fair to challenge its usefulness as a tool for traders in general and for the self-directed retail investor, in particular.
First thing you need to do, is to set up your expectations. As with any model backtesting has limitations.
Human Limitations: By far the most important limitation of the backtesting process is the capacity of the investor to execute the strategy.
Humans are vulnerable to their whim, emotions, sentiments. Defending equity during adversity is considerably more difficult and stressful than any testing can imply.
You’re asking to set fear and greed to the side. You are asking the very basic wiring of the human brain to be short circuited. When the risks are relatively low, when the volatility is relatively low, and things are kind of going your way, no problem. But in hardship, the stress factor of trading can not be underestimated
Technical Limitations: Options data tends to be huge. Millions of data points needs to be collected, organized and indexed. This tends to be an expensive process. Fortunately today’s tools allows us to deal with gigantic data sets and stay within reasonable costs.
The size of your trade may impact the price at which you can be executed. For the retail investor this is a minor issue. More important is to stay with liquid underlings so that execution of the trades can always be performed within the historical bid & ask ranges.
False expectations: Backtesting is not the route to the golden goose. There is no one for all magic solution. It’s a process. Backtest works on empirical historic data. The past will not happen again. Nothing in a backtest process should lull you into an illusory sense of security.
Practice: You may not adhere to Malcolm Gladwell‘s principle of “ten thousand hours is the magic number of greatness.” But if you believe that trading is a skill that can be learned and perfected, practice is essential. Backtesting provides a easy, risk-free, interactive and fast way to practice your trading skills.
Validate your intuition, keep your intuition in check: Traders need intuition. But you can help your own intuition with empirical evidence. So next time you have a hunch test it. Then test it and re-test it again, before trading. Your ego may take a hit, but your account balance will thank you.
Be mechanical, have a plan: Having a clear plan will help you when the market goes against you. Think of all the drills people develop to know exactly what to do when the unexpected happens. When the emergency finally arises. Backtesting helps you to develop that plan. You can visualize the life of your trade and see the drawdowns, the largest losses, and picture your self exactly at those times.
Master your tools. Option trading is peculiar in the possibilities and choices it offers. Buying stock is a 50/50 shot: the price goes up and a trader profits, or it goes down and a trader incurs losses. With options, you are able to choose the price at which you buy or sell, ultimately improving your probability of profit. You can also select your direction, risk level, leverage. You can protect your downside risk: “define it”or go “naked”. Once on a trade, you can defend the position, roll it out in time to give it more duration -get more time to be right- or exit. You can close the positions as they reach a certain level — a pre established profit target — way before expiration. There is a panoply of tools at your disposal. Backtesting helps you understand those tools and their respective repercussion on the outcome. One by one, or combined. At your pace. At your will.
Confirm others peoples claim . There is an over abundance of tips, “sure” or “best performing ever” strategies. How do you corroborate their claim?. Maybe it is a sound trade and you could miss an opportunity. Well, test-it. Test before you jump and commit to the trade. At the very least you can understand why the author is advising the trade.
Market conditions Impact: As market conditions evolve so do strategies. Grasp these relationships, see how much they impact one trade vs another. For example, test and observe one strategy on a volatile market period. Then switch the underlying and compare the two. Are both affected in the same manner? Can you develop your own set of heuristics, your own rule of thumb?
Assess your risk tolerance: The winning strategy for you may be too risky for your neighbor. The total end Return of a strategy may have you craving. That is until you see the losses, and the variability of the trade. You then settle for a less juicy return but less risky trade. Seeing live the level of risk you would be incurring, will make you realize if that trade is adequate for you, or for your neighbor.
Just like a flight simulator. Nobody will argue the contribution to general flight safety of the flight simulators. It’s not the real thing. It can’t be. But a good one, is as close as it can get. And crashing is not a life ending experience.
A silver bullet, yes. But is it a good silver bullet? So lets assume for a moment, that you accepted the theory here presented. That you agree that backtesting options is an essential — useful — money saving process. Now we must evaluate the quality and usability accuracy of the simulator.
For example, IMHO a simulator that requires re programing for each run is of limited use. To harvest the benefits described, you need a really fast and ideally interactive application. One where you can see in real time the consequences of your adjustments on the results.
Also, you should be able to compare, side by side, your different tests. Replay them without restraint and keep them organized for future reference.
Finally, if you are going to trade to attain your financial objectives, you better enjoy it. It needs to be fun. Your ideal tool, your simulator, should be fun to use. You should enjoy the process. Just like anything you do with passion.
Let me finish with this post from Mike Gavone.
What do you mean “no one has fun backtesting”? The part of trading that keeps me most excited is trying to think of new ideas and then backtesting them to check their robustness. In fact, I would think a trader would be more likely to follow a system they thought was profitable, if they could code it up and the backrest proves them correct. I didn’t know how to code, don’t like to, and still consider myself an amateur at it. However when you see that 20 year equity curve shows you’re probably on to something, it’s a really good feeling.
Mike Gavone — desiretotrade.com
The Basic Backtesting Workflow. How to setup and optimize a study based on empirical historical data. Step by step explanation with a real-life example.