Options Theory: Baby Got Back(testing) Part I: Why? | Tackle Trading

I have a confession to make — I never used to backtest, ever. Blame it on my ignorance. First, I had no idea what it was. Second, when I did learn about the concept, I didn’t fully grasp its benefits. And third, I really didn’t know how to do it.

Then, I started getting more systematic in my trading and necessity demanded I shed my ignorance and figure out how to do it. And now, I’m converted! There is no doubt I’m a better trader, and I’m therefore convinced everyone should use backtesting to some extent in their trading. At least, if you want to make money.

In this series of articles we’re going to look at the what, why, and how of backtesting. So buckle up and hold your head still so nothing spills out.

Here’s how Investopedia defines backtesting:

“Backtesting is the process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital. A trader can simulate the trading of a strategy over an appropriate period of time and analyze the results for the levels of profitability and risk.”

Here’s how I would explain it to the layman. Hey, Jimmy! Before you risk your hard earned money buying options straddles in Microsoft stock every month, wouldn’t you like to know if that particular trading strategy even generates a profit? Of course, you do! So backtest it! Create a set of rules, complete with entry, management, and exit rules. Add in position sizing and go back and see how that system performed over the past six months or two or five years or whatever.

I can think of numerous benefits to the exercise.

First, it tells you if your system has made money over time. I’m assuming that’s your premise. Otherwise, you wouldn’t have crafted the system in the first place. Apparently, you think your strategy has an edge (i.e., should make money) so put it to the test. If it doesn’t, in fact, earn money over the backtest then you can either modify the rules and try to improve the performance, or scrap it. Better to figure all that out before committing your capital, right?

Second, it tells you what to expect. It is imperative when you begin any new strategy or system that you understand exactly what you’re signing up for. Think of a stock investor who plows a bunch of money into the S&P 500 and then two years in a bear market strikes, and he sees his beloved portfolio drop 30%. Disgusted he abandons ship and sells everything at the lows. Then when the market recovers without him, he swears off stock investing. Here’s what I would ask this investor: What did you expect? Were you not aware that bear markets are commonplace? That the stock market drops 30% once or twice a decade? It’s the nature of the beast, friend!

If he would have taken the time to understand the history of the market, then perhaps he would have succeeded. This is what backtesting can do! It can tell you what’s typical with your strategy. What’s the typical loss? What’s the typical gain? How often do you usually lose? What’s the longest losing streak?

If you know the totality of potential outcomes — at least those experienced over your backtest — then you are better equipped to weather the ups and downs of the system moving forward.

Just as someone socking money away in a retirement account better understand the volatility and average returns of stocks, bonds, and any other asset class they’re investing in, an iron condor or covered call trader better understand the expected volatility and returns they will face. Otherwise, they’ll probably buy or sell at the exact wrong time!

Third, it provides the confidence you will need to stay the course during losing periods. Traders who don’t take the time to build a system, let alone backtest it, are quick to give up after losing trades. See if this doesn’t sound familiar. A new shiny strategy catches your eye (let’s say it’s selling Iron Condors on the SPX every month). You try it once or twice on paper, and it works. Then you start trading live. You win one month, two months, then three months. On the fourth month, you lose, giving back all your gains in the process. In frustration, you vow never to trade condors again. Then you search for a new strategy. Rinse, wash, repeat. Because you had no context, no understanding of what was typical. You were quick to quit.

I know traders who have missed out on thousands of dollars this year because they quit trading the Cash Flow Condors system after last November’s election caused them to have a losing month. Do you know why? Because they had no context nor confidence. They hadn’t personally done a backtest and simply didn’t trust the strategy to work anymore. Essentially, the first time it got hot in the kitchen they bailed.

With a backtest I know just how hot it can get in the kitchen. I’ve obsessed over the temperature gauge for a long enough period to know it inside and out. I know what type of clothes to wear, the appropriate apron. I know how the food will taste on a good day and a bad day. Consequently, I’m rarely, if ever surprised. Do you see how that would make you a better trader?

Those are three big WHYS for backtesting. Next time we’ll take an in-depth look at WHAT goes into building a system and HOW to backtest it.

# Sign up now for a 15-DAY FREE TRIAL #

Financial freedom is a journey

The Options Theory series is brought to you by Tackle Trading.

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.

Originally published at https://tackletrading.com on October 1, 2017.



Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store