Backtesting for Options Traders

02/28/2012 2:00 pm EST

Focus: OPTIONS

Jackie Ann Patterson

Author, Truth About ETF Rotation

Option-specific factors like expiration, volatility, and trade structure makes the process much more complex, but option traders can (and should) try backtesting, says Jackie Ann Patterson.

Trading strategies are very familiar to stock, index, and futures traders, but what if you’re an options trader? Can you backtest an option trading strategy? 

Our guest today is Jackie Ann Patterson to talk about that. So Jackie, can I backtest an option trading strategy?

Well, Tim, you certainly can. The thing is, it’s going to take a lot more work than backtesting a stock or an index strategy. 

With stocks, basically, you enter, say you buy, and then you sell. You can add up what happened profit wise, and that’s pretty much it; cut and dry. But with an option, there’s just so much going on. 

You can backtest what’s happening with the underlying stock and see how often it wins, but when it comes time to add up the profits, it takes a lot more to look at the option. Look at which expiration, look at how much it may have moved, say, if the volatility in the market has gone up, the option price may have gone up. 

It does make sense to actually backtest with the option data. That is certainly available, and you can do it either manually, or you can also automate it to a certain extent. 

Some of the choices, though, that go into the trading strategy for options, takes it to another level if you are thinking about automating it in terms of choosing expiration dates and whatnot.

I would imagine it gets a lot more complicated, too, when you’re talking about spreads and iron condors and butterflies. How many do I buy, how many do I sell? You could try to optimize this thing forever to get it just right. When is enough enough and you should just start trading it? 

I think once you have a good sense for how the system is going to perform, and you can answer some of the key questions like, "Which expiration should I target?"; "How far in the money or out of the money do I want to be?"; and "What are the optimization tradeoffs?", then it’s probably a good idea to start trading

Trade small with real money, see how it feels, and see how it really goes, and then see how the changes in the volatility affect you.

I can see this being a really good way to do it around earnings. I can see how options have reacted previously around earnings announcements for a specific stock. Is that a valid idea?

Yes, I think that’s a really good idea, and it’s really important to see not only how the stock reacts, but also how the options do, because often coming into earning season, there will be a build-up of implied volatility, the option prices will go up, and once the earnings are announced and the situation is known, that quickly collapses. 

That is a really interesting thing to look at and to know something important to be armed with historically.

How about weekly options? Can I test the weeklies versus regular options versus maybe LEAPs?

Yes, and it certainly is worth having a look at. It’s going to be harder to automate that and harder to find the data, especially since the weeklies are a more recent invention, if you will. But it’s definitely worth taking a look at and making an informed choice of which type of option you want to trade and what’s really going to suit you the best.

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