Beginner
17 Minute Read

Options Theory: Baby Got Backtesting Part 3 – Backtesting Execution

October 15, 2017

By | 2 Comments

In the System Development 101 series, we will teach you how to build your own successful trading system from scratch. Click on the image to get instant access.

Last update: August 2021

Backtesting Series [FREE Articles]

Welcome to the third and final installment of our series on backtesting. If you missed the first two be sure to check them out here and here.

You selected a strategy and systematized it, and now you want to see how it would have performed.

Options Theory: Baby Got Backtesting Part 3 - Backtesting Execution

First question, what’s your lookback period?

You already know I think you should include bull, bear, and neutral market environments in the test. How far back you have to go to find it depends on your system and how frequently the signals are generated. If you enter a new trade every day, then you probably don’t need to go back five years as that would give you some 1,260 (252 x 5) transactions to sort through.

So why did I use five years for the Condors system? Well, because only one trade is generated a month. To get a decent sample size (60), I had to go back that far.

Second question, where do you get the data?

If you’re testing a stock trading system, then the answer is obvious! Use a chart, any chart. You can manually track the signals and jot down the buy/sell prices to follow your profit and loss. Here’s an example of a moving average crossover system:

$SPY Chart

If you’re trading options, then you need to be able to pull up the price quotes from the days you would have entered or exited the position. For that, you need historical data. There are numerous sources for this, but the one that I’ve always used is my broker (ThinkorSwim). They have two features called OnDemand and ThinkBack (available under the Analyze Tab).

Both features allow you to go back in time to see the pricing of options at various dates. The primary difference is that OnDemand will enable you to see intraday prices and ThinkBack only provides end-of-day pricing. I’ve always used ThinkBack personally because I’m more familiar with it, but I can see the advantage of being able to see the intraday price of an option to better gauge where I would have been filled at. How much of a benefit this depends in large part what type of system you’re trying to backtest.

Thinkorswim ThinkBack Tool

A comprehensive explanation of the ThinkBack feature is outside the scope of today’s article, but to provide you with enough to get started let me show you how to get started.

$RUT ThinkBack on TOS
  1. One: Go to the Analyze tab
  2. Two: Select ThinkBack
  3. Three: Select the date you want to view options quotes for
  4. Four: Build your trade using the options chain
  5. Five: You will see your “Backtrade” displayed down here
  6. Six: The P/L Open column will change as you modify the date so you can see how much money your position made over time.
  7. Seven: Perhaps one of the coolest features is the P/L Graph shown at the bottom. Think of it as the equity curve for all of the trades you’re compiling throughout your backtest. It provides a sense of how much fluctuation you would have experienced in your system over time. Not to mention the overall profit or loss accumulated.

To organize your trades, I highly recommend using the Tackle Trading Journal. I use this for all my systems and absolutely love it for a couple of reasons. First, it automatically draws an equity curve so I can see the path my system followed over time. It allows me to visualize the blow-by-blow action of the fight. Additionally, I can view how many drawdowns I experienced over the test and just how severe they were.

Trading Journal Equity Curve Chart

Second, it calculates all the key metrics we need to assess the efficacy of the system. Here are the top ones: # of winning trades, # of losing trades (from these two metrics you calculate percent profitable), average profit on winning trades, average loss on losing trade, total gain/loss for the system, longest losing streak, largest winning trade, largest losing trade, max adverse excursion (basically the largest drawdown experienced over the testing period).

I customized the numbers a little bit when I backtested the Condors for Cash Flow system and organized them by year. My final spreadsheet that pulled everything together looked like this:

In closing, allow me to address a few questions I received that weren’t answered in this series so far.

Backtesting FAQ / Q&A

Q: What do I do after having backtested a system and found it to be profitable?

I suggest moving into the paper trading stage. Consider this your forward testing. The goal is to make sure you can execute the system in a live environment to see if it still works and make sure you’re comfortable with the order entry and management process in real time. Once you’ve paper traded successfully, then move into live trading. If you want to be conservative, then start with a small size first before working your way up to normal.

Q: What are some of the potential hiccups to be aware of when using a new system that you have backtested but not yet forward tested?

Fill rates. When you backtest, you assume you would have been able to get your orders filled when needed. But in a live environment sometimes that can be tricky, particularly if you’re dealing with an illiquid option. You may have to modify your order multiple times by changing the price before you are filled. This adds a bit of stress and time to implement the system.

Q: Can you backtest hedging tactics?

Yes. You can backtest anything provided you’ve specified the rules for entry and exit. Depending on how often you end up hedging this will increase the complexity of the backtest and the number of trades you’ll need to track.

If you’ve made it this far, you deserve a reward! Here are two recent Cash Flow Clubs I taught about all things backtesting (PRO Members only):

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.

Tackle Trading Resources on Journaling

Trading Journals are essential for any successful trader. Click on the image to purchase our Trading Journals Bundle at a special price.

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.

Access the Trading Journals

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!

Tackle Trading: Financial Freedom is a Journey. Sign up now for a 15-day free trial.

Financial freedom is a journey

Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.

Sign up now for a 15-DAY FREE TRIAL

Legal Disclaimer

Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.

All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.

2 Replies to “Options Theory: Baby Got Backtesting Part 3 – Backtesting Execution”

  1. MARIADIAMOND says:
    October 15, 2017 at 12:03 pm

    thank you very much Taylor! Finally I can put my hands on it!

  2. PETERIRUNGU says:
    April 3, 2018 at 3:37 pm

    Thanks Tyler for explaining this tough concept simply.

Comments are closed.

© Tackle Trading 2024 All rights reserved

Chart Modal

Tackle Trading
Forgot password?

Lost Password | Join Today

Book a FREE Consultation

Sign up for a free consultation to build your Educational Plan.

Talk to an expert