I've mentioned that I had a rough March. The markets did their part to make it rough, but I did my part, too. Because of the combination, I essentially worked for free for many months because I wiped out many months of profits. What happened that month led to much back testing or back trading. I searched for something that might smooth out my returns.

Perhaps I have a different attitude than many people, but once I'm past the grieving over a loss, I'm typically grateful for the lesson that's been delivered. My lesson this time is that I can't let unrealized losses accumulate, even if I think I'm never going to realize those losses since I intend to roll. Sometimes occasions occur when a roll isn't possible. Those may be due to lifestyle issues. Perhaps a trade that can't be tended must be unexpectedly closed. It could be due to something like what happened on May 6. I've heard stories of some with portfolio margining who suddenly found themselves overextended and getting margin calls. They had to liquidate positions that were currently under water but had every possibility of being profitable at expiration. In at least one case and probably many, many cases, risk managers at certain brokerages liquidated positions without first consulting clients, as is their right to do in most brokerage contracts.

My new goal is to find a way to keep those unrealized losses from growing larger than some preset level that's appropriate for me and my trading style. Of course, nothing I do can guard against a Black Swan event, but I'm talking about normal trading, even in rough times. There's got to be a tradeoff to everything, however, and I knew my tradeoff for smoothed returns would likely be smaller average returns. In fact, that's what the back trading showed me. I'm not going to outline what I'm doing in great detail because I've only gone live with it for one month, and there's often a real disjunction in what we see in back trading or back testing and what develops in actual trading.

That's particularly true since the methodology I'm testing involves combining my former incarnation as a day trader with my current incarnation as a more staid income trader. What I'm trying to do is step in earlier on adjustments with extra back-month longs or puts, before an unrealized loss can accumulate. However, doing so murders the expiration curve. For example, if I've taken in $3,750 in credit on a 25-contract iron condor, spent about 10 percent of that to buy an insurance put, and paid commissions, I'm going to wipe out a whole lot of profit potential if I have to buy a long back-month call for $17.00. Maybe under my new guidelines I need that call to hedge half my price-movement risk after a large upside move, but that's going to murder my expiration graph.

What am I going to do about that? I could just leave the extra long call on unless and until I need to roll the call spread or until expiration. Or I could take it off when the conditions for putting it on are reversed. That last tactic is of course risky and open to much opportunity for failure from slippage and user (that would be me) error. Therefore, I ran through about 30 months of back trading. I know better than to trust all back trading results to translate into live trading, but I did my best to introduce some slippage into the back trading.

I didn't expect a guarantee of what I might make. In this test, as in others I test, what I wanted was to determine was whether there was a glaring reason why this shouldn't even be attempted. I feared that all the trading in and out of those hedges would result in a spectacular failure over a number of months of trading, even if I set up guidelines for when I would trade in and out.

It didn't. It did, however, show me that I was right in supposing that my conditions for putting on and taking off the hedge would result in a lot more trades, a lot more opportunities for slippage, extra commissions and deer-in-the-headlight syndrome to take their toll on the overall profits. In the May expiration cycle, I put it to a live test for the first time.

The May expiration cycle proved to be a difficult one as many already know. I entered a 50-contract SPX iron condor on April 5. After commissions and spending about 10 percent on an insurance put, I ended up with a margin requirement or buying-power effect of $44,390.32. By April 14, with the SPX speeding higher, I was making my first adjustment, buying a long call position. That call position of course added to the margin requirement or buying-power effect of the position, driving it up to $47,468.37. Another call on April 15 brought that margin requirement or buying-power effect up to $54,612.25, which was to end up being the highest that position required. That means that all profits and losses would be measured against that margin requirement or buying-power effect.

I traded in and out of hedges, and, as expected, lost money on the hedges. After all, I was putting them on when certain conditions threatened my trade and took them off when those conditions no longer existed. I was by definition of my own guidelines going to lose money on them. The idea wasn't to make money on the hedges, but rather to use them to make sure that my unrealized losses never mounted too high and that I could stay in the trade. A secondary goal for me was to set up conditions so that if prices kept going and it was necessary to roll, my hedges would have been profitable at that point. Collecting that profit when I rolled would undo the necessity to roll into 1.5 to 2.0 times the number of original contracts as I had been doing previously. Rolling into that many extra contracts increased the risk I was accepting, and I wanted to avoid that in the future if I could. Therefore, during the test, when I rolled, I rolled into only 20 percent more contracts.

When I closed that position on May 5, I collected a measly $2,447.08 for the trade, only 4.48 percent of the maximum margin requirement or buying-power effect encountered during the trade. Iron condors aren't known for their high returns on margin withheld, but the effect I had anticipated had indeed occurred. If I elect to continue this policy, I'll hopefully smooth out my returns, but the average gain will suffer.

The proposed methodology was put to a good test. That month did see a lot of trading in and out of the hedges. Still, the trade survived and I did make money. Luckily for me, that profit was available on May 5, and I jumped on it.

I was talking to another experienced iron condor trader about these results. He suggested that I put the back testing to a test. Since I'd completed the May trade, he suggested that I back test the same iron condor, put on the same day. Great idea, I thought.

In the back test, I opened a 50-contract iron condor the same day as the live one had been opened. After that, the trades diverged. The maximum margin requirement or buying-power effect was $61,232.12, higher than that in my live trade. I closed this trade one day earlier than my life trade, on May 4. The profit was higher, $3,330.04, and the percentage of the margin requirement or buying-power effect, 5.44 percent, was also higher.

Why was there a difference? In the back-traded test, I closed all 50 contracts of the bull put spread on April 15 for $0.15. In live trading, I tried for more than a week longer before I could close any of those bull put spreads for $0.15. On April 23, 30 were closed for $0.15. I remember at the time being frustrated that I kept seeing times when my standing orders "should" have been filled but weren't. And, on the day that those 30 filled, the rest did not. The presence of those puts in the trade for an extra 8 days of course made a difference in the profit and loss showing up during the ensuing days. And, when I eventually closed the other puts, it was for a greater amount, although a hedging put position I'd bought did partially offset the extra cost. But the moment those puts filled in the back trade and didn't in the live trading, the trade diverged, of course.

What are the lessons here? We who have traded for a long time know that there are conditions under which we're just not going to get fills at the expected prices. I anticipated that when I thought about how the back testing or back trading might diverge from live trading. This process is akin to the testing of new drugs. The first test is to see whether it had adverse effects in the lab. That's what the back trading was doing. Now there's a new round to see if it kills the patient. In drug tests, there might be another round in which it's determined whether the new drug will actually prove of benefit. In putting back-traded results to the test, those last two rounds will be combined. In live testing, I'll be able to tell whether live trading murders my results and whether it benefits me, both at the same time.

Is an $882.96 lower earning in live trading as compared to back trading significant? You bet it is. However, I've seen occasions when I get fills that I shouldn't have gotten in live trading, especially when markets are jumping around in the mornings and I'm unexpectedly able to lock in profit on a spread. Will it all even out in the end?

I don't know yet. So, what's your takeaway point from this discussion? Perhaps you've done some back trading for yourself and you're ready to go gung-ho into a new system. Or perhaps someone has sent you back-traded results of some method that's being touted as the holy grail. Be skeptical of your own testing or someone else's. Be pragmatic. If you're going to put it to the test in live trading, do it in a smaller amount. Fifty contracts for a month's trading is a smaller amount for me than is typical. If you're used to trading 6 contracts and are thinking about a different methodology based on back-traded results, consider a 2-contract trade until you're sure that back traded results can translate well into live trading.