Last update: August 2021
Backtesting Series [FREE Articles]
- Baby Got Backtesting Part 1 – Why Backtesting?
- Baby Got Backtesting Part 2 – How to Backtest?
- Baby Got Backtesting Part 3 – Backtesting Execution
- Cash Flow Club: Backtesting Trading Systems Part 1
- Cash Flow Club: Backtesting Trading Systems Part 2
In the first part of our backtesting series (see here), we explored the what and why of the process. Today we get down to brass tacks and talk about how to go about backtesting.
System Building
Long before you can even venture into the backtesting arena, you have to create a system. Otherwise, you have nothing to test! System building is a monster topic in and of itself, so I’m going to give you the simplified version here. First, let’s differentiate between a strategy and a system. A bull put spread is a strategy. Anyone can learn the basics of a strategy –its structure, risk, reward, and so forth. But a system goes well beyond that. Here’s an example of a simple bull put spread system on SPY.
- Entry: 45 days to expiration if SPY is above the 50-day moving average then sell a $5-wide bull put spread where the short put delta is less than 10.
- Target: Ride to expiration and allow the spread to expire worthless.
- Stop: Exit if the short strike price is reached.
- Position sizing: Only risk 1% of account size
What makes a good system? Well, let’s start with the obvious – it makes money over time. That’s its edge. It also needs to be used on a liquid product that you can trade in and out of with ease. And, it needs to be sized appropriately so you can withstand losing streaks. Finally, it has to be something that fits your personality and risk tolerance, so you’ll have the ability to execute with consistency.
The Cash Flow Condors video series is a prime example of a properly built system that can print profits over time.
If you’re wondering what type of strategy you could use to build a system around, here are my top two suggestions.
First, start with what you know. If you’re just starting out and are familiar with covered calls, then use that.
Second, use a strategy you’ve had some success with in your paper trading. It should be one that you think you have the ability to systematize and consistently deploy. When choosing your underlying, I suggest starting with an ETF or an Index, so you don’t have to worry about earnings gaps mucking up your results.
When Paper Trading Falls Short
Notice how the first characteristic of a good system mentioned above was its ability to make money over time. That is what backtesting is all about – discovering if your system does indeed produce a profit. Now, you might be thinking that this is what paper trading (aka virtual trading) is all about. And you are correct. But, think about how much time it would take to rack up a large enough sample size to draw meaningful conclusions – especially if your trade duration is weeks. That’s the first drawback to relying solely on paper trading. It could be months before you have sufficient data to determine if your system idea is a good one.
Backtesting speeds everything up. When I went through the process with the Condors for Cash Flow system it only took me a few hours to see how it performed over five years of data.
A second drawback to testing your system only with paper trading is it doesn’t really test its robustness over varying market conditions. Suppose you practice trade the bull put spread mentioned above for the next six months and all the market does is rise. You’ll probably win every trade, but was that a valid test of your rules? Not really! You need to see how you fare not just when the market rises, but also when it falls or stagnates. This is where backtesting helps. You can cherry pick the months (or years) you use to ensure you get a good variety of market conditions.
For the Condors for Cash Flow system, I chose a five-year window from 2011 to 2015. It included some large down moves (2011 saw a 20% market drop), some large up moves (2013 saw a 30% rally) and some stagnant markets (2012). And to be extra sure the system could weather a vicious bear market I also tested to see how it fared in 2008.
Stay tuned for our third and final installment where we’ll move into how to actually execute your backtest.
Tackle Trading Resources on Backtesting
Why backtesting? What are the benefits? How to run backtesting? How to collect and analyze data? What types of trading systems can I backtest? What are the tools available to run backtests?
These and many other questions have been already answered in our extensive pool of articles on backtesting.
Tales of a Technician: Perfecting Your Process Part One
Traders should be process-oriented, not results-oriented.
Tales of a Technician: Perfecting Your Process Part Deux
Today we continue our carefully crafted tale on how to perfect your process.
The Day I Discovered the Wheel: Backtesting
For all of you, who just like me, felt insecure about a certain strategy, and how to apply it, I have one thing to tell you: BACKTESTING!
Options Theory: Baby Got Backtesting Part 1 – Why Backtesting?
I have a confession to make – I never used to backtest, ever. Blame it on my ignorance.
Options Theory: Baby Got Backtesting Part 2 – How to Backtest?
In the first part of our backtesting series, we explored the what and why of the process. Today we get down to brass tacks and talk about how to go about backtesting.
Options Theory: Baby Got Backtesting Part 3 – Backtesting Execution
Welcome to the third and final installment of our series on backtesting. You selected a strategy and systematized it, and now you want to see how it would have performed.
Tackle Today: Back › Forward › Live
Backtest › Forward test › Go Live. The antidote for the risk of ruin.
Friday Feature: The Scouting Reports Backtest Series Part I: Why I started the backtesting
Have you ever wondered how well the Scouting Reports picks actually perform? This is what I am answering with this 3-part series on the Scouting Reports backtesting.
Friday Feature: The Scouting Reports Backtest Series Part II: What I learned from backtesting
Have you ever wondered how well the Scouting Reports picks actually perform? This is what I am answering with this 3-part series on the Scouting Reports backtesting.
Friday Feature: The Scouting Reports Backtest Series Part III: How backtesting shaped my trading
Have you ever wondered how well the Scouting Reports picks actually perform? This is what I am answering with this 3-part series on the Scouting Reports backtesting.
Friday Feature: The Scouting Reports Backtest Series Epilogue
“[…] It all comes down to mindset. Chipper talked about how it takes a strong will to be able to fail 70% of the time and press on, practicing, playing, and striving to be better without the failures weighing down on you.” Trust your system, traders.
Tales of a Technician: Backtesting 50-day Moving Average Signals
Come learn about why the 50-day moving average generates powerful trend reversal signals.
Friday Feature: How the S.T.E.P. System helped me build my rules
I used the information that was in the S.T.E.P. System to refine my trading plan to fit my personality. Continue reading.
Tackle Trading Resources on Journaling
Trading Journals
Good traders keep excellent records. Quality trading journals are essential to your progress and growth as a trader and keeping good records will help you learn more from both your income and expense trades.
Learn more about HOW the Tackle Trading Journals can help you become a professional trader.
Trade Journaling for Beginners [Free Articles]
Continue learning about this powerful trading tool: the Trade Journals. Tackle Trading has all the resources you need to MASTER them like a PRO. From the Trade Journals themselves to free articles and tutorial videos on how to make the most out of them, we got you covered!
How to use the Theta Research Tool to find the best stocks for Cash Flow
In this video tutorial, Coach Matt goes through the latest edition of the Options Research Spreadsheet explaining how to use it to find the best stocks to cash flow.
How to use the Theta Research Journal to find cashflow candidates
In this video tutorial, Coach Tim teaches how to find the best candidates to trade cash flow options strategies using Tackle Trading’s Theta Research Journal.
Tales of a Technician: Journals, Systems and Discretion
Once upon a time I didn’t use a trade journal. Then I got smart.
Trade Journal Series: How to use the Theta Research to find Covered Call candidates
In this video tutorial, Coach Tim Justice teaches how to find the best candidates to trade the Covered Call options strategy using the Theta Research tool.
Trade Journal Series: How to use the Trade Journal
In this video tutorial, Coach Tim Justice will teach you how to use a powerful trading tool: the Trade Journal.
The Day I Discovered the Wheel: Backtesting
For all of you, who just like me, felt insecure about a certain strategy, and how to apply it, I have one thing to tell you: BACKTESTING!
Tackle Today: Organization is Key Part 1 – Trading Business
You might’ve asked yourself at a certain point: “How should I start to make this trading activity a business?”
Tackle Today: Organization is Key Part 3 – Trading Journal
A Trading Journal is not something superfluous. It is crucial. Continue reading.
Notes from a Newbie: The Trade Journal is your friend
The trade journal is your friend, use it!
Options Theory: Size Matters
Do you have consistent position sizing and are you tracking your trade stats? If not, then here’s your invitation to start.
Friday Feature: Habits of a Wealthy Trader – Part 2: Journal Your Trades
You need to treat journaling as a fundamental step in your data and behavior analysis to help you succeed.
Tackle Today: Organization is Key Part 2 – Business routine
Like any other business out there, your trading business must have a routine. Continue reading.
Women in Trading – Journaling
Journaling: I know based on my own experience that it is the most dreaded topic when it comes to trading, yet it is an important part of a trader’s journey.
Financial freedom is a journey
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