Traders ask: How do I get the most out of my options back testing exercises?

An active member of SMBU’s Options Tribe Community submitted the following question to me recently:

Dear Seth,

Hope this email finds you well

I’m planning another set of back tests for my M3 style of options trading (yeah another one…… together with the Bearish Butterfly I think it’s now my fourth pass at this, but who’s counting when I’m having so much fun!)
Anyway….I have a dilemna that I was hoping that you could help me out on.
In my back testing plan, I’m mapping each trade initiation during the years 2007-2016 into different trade environments: sell offs with high volatility, choppy markets, lengthy upward moves with periodic small price pullbacks and so forth. All in all I think that it will be around 6-7 market environment “clusters”.

The purpose of this back testing exercise is to practice adjustments, understand better the mechanics and risks of the trade under during each of the clusters as well the shift from one environment to another during the life of the trade.

My question is this: what would be the best approach to get the optimal learning experience in this process? I see three basic alternatives:
1. Practice each cluster on its own, master it and then move to the next cluster
2. Test a couple from each cluster until all clusters are completed.
3. Back test through each calendar month sequentially, noting into which cluster each trade falls, and what techniques seemed to work in each cluster.

Your insights and thoughts would be greatly appreciated.
–Shai from Israel.


Shai, outstanding insight! Your recognition that markets are different and may call for different adjustment techniques is very advanced thinking as a market neutral options trader. My immediate reaction is that you should start with one particular “cluster”, take careful notes and experiment with different approaches to that cluster until you have found an effective way to trade that cluster. Then move on to the next cluster and repeat this ‘optimization’ process. The one downside that I see is that you will lose the valuable experience of trading months in their actual sequence to get a feel for how one type of market flows into another and the ramifications of those shifts on the trade. To overcome this, drawback you might consider, after “optimizing” each cluster, going back and doing a thorough chronological back test using the rules you have developed for each cluster during some five year period that seems to represent lots of different kinds of markets. It’s a lot of work but will no doubt prove exceedingly valuable. Back testing is a great way to build trading “muscle memory”, develop alternative approaches to handling market situations and build confidence in the strength and robustness of what you have built. When you’re finished your work, let’s get you on the Options Tribe to present your findings!

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