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Options Theory: Baby Got Backtesting Part 2 – How to Backtest?

October 8, 2017

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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

Options Theory: Baby Got Backtesting Part 2 - How to Backtest?

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.

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