Recently, I received a mailer from an options-trading pundit. The author put down the whole idea of backtesting. The premise of his criticism was that back-testing cannot replicate the emotions or even all the conditions--slippage, etc.--of live trading. He went so far as to suggest that back-testing was harmful, misleading the would-be trader.
Different likes and dislikes for different people, different opinions for different people: that's what makes the world go round. However, I beg to differ with this particular pundit, as experienced as I know him to be. The worth of back-testing rests on what you expect to gain from back-testing. When I talk about back-testing in my articles, I warn that back-testing cannot predict the results in live trading. However, the practice is far from worthless and certainly not harmful if used as it should be.
When I was switching from trading iron condors to trading butterflies, I was already an experienced options trader. I was well-acquainted with slippage, fills that never happen, and the emotions of trading. Still, I backtested all kinds of permutations for the trade I wanted to try: RUT vs. IWM, RUT vs. OEX, hedging with deep-in-the-money long calls versus verticals versus long straddles. The idea of hedging with long straddles was soon thrown out the window. Why? Back-testing showed it just wasn't a viable strategy for my trading needs.
That's the first benefit of back-testing. You can weed out a strategy that produces results you don't like on back-testing. Why even try a trade that fails on back-testing? Or why try a trade that succeeds in back-testing but clearly doesn't meet your needs as a trader? Perhaps the profit is impressive after you've run through 30 back tests, but along the way, the trade often produced big drawdowns one month after another. Most traders who know themselves would know that they would not be able to stomach such a roller-coaster ride.
The second benefit of back-testing is that the practice forces you to realize that even a sound strategy produces losses. Even a profitable month in a monthly strategy likely shows days when there's no profit. Back testing produces a record of how the trade behaves over time. For example, let's look at my live RUT butterfly trade as of Friday, August 29.
Live OCT14 RUT Butterfly as of August 29, Shown on OptionNet Explorer:
I've been in this trade 15 days at the point illustrated here, and the choppy RUT moves have not produced any profit yet beyond what's needed to pay for most of the two-way commissions. The trade still has $47 to go to earn back all the commission cost. If I were new to trading this trade, I might be getting especially fearful that this trade isn't going to work, especially since I knew the next week had many economic developments or releases capable of moving the equity market.
Emotion attaches itself to the trade, with the depth of that emotion somewhat dependent on the trader's experience with the trade and the markets. For the new trader or the trader new to this trade, back-testing the trade does nothing to prevent those emotions from attaching themselves to the trade and worrying about the next week's upcoming events, just as that pundit warned.
However, because I back-tested this trade--and, fortunately, for the sake of this article, didn't destroy all the back-tests--I can scroll through my records and find out how the trade looked at other times 15 days into the trade. Here's one example for a month that ended up reaching my max planned profit.
A Back-Tested Hypothetical Trade as of 12/08/11, 15 Days in Trade, Shown on OptionNet Explorer:
And another similarly constructed back-tested trade as of 2/07/12, 15 Days in Trade, Shown by OptionNET Explorer:
The March-expiration trade depicted on February 7, 2012 also reached full planned profit, although it was not as profitable as the previous trade.
What does looking back at these back-tested trades prove? How did these back-tests help or hurt?
In all three cases--my live trade on the date depicted and those two back-tested trades from late 2011 and early 2012--the profit and loss line was either slightly above or slightly below the flat-line level at fifteen days into the trade. Yet the two back-tested trades did go on to be profitable.
The back-testing did not guarantee that just because those two trades went on to achieve their planned profit potential that my current live trade will do so. If I had been a newbie trader in this trade, they would not have erased all the emotion that I might have been attaching to the possible disruptions of the upcoming week in my then-current live trade, including the non-farm payrolls. However, I could follow a number of such back-tested trades through to completion and reassure myself that, over time, the back-tested trades did tend to work although they might not do so in a particular month. Reviewing those back-tested results would have reminded me why I was managing the trade the way I'd chosen to manage it, and might have quieted some of those fears.
Or perhaps, they would have prompted me to choose adjustments that reduced the risk in the trade as the trade headed into a difficult week, choosing caution. That's what experience beyond the back-testing has taught me. However, when I first began trading this trade, I needed the back-tested results to review to avoid getting too caught up in the emotion of the trade. The back-tested results helped me manage emotion when trading live.
Some traders complain that they just can't pay attention to a trade unless it's a live trade. Back-testing and simulated trades just don't work for them, they say. That's fine. In addition, some traders complain that back-testing can't replicate fast-market conditions, days when we just can't get a fill because the volume is so low, and other such conditions. That's true, too. No one should count on being able to replicate back-tested results exactly, but, even for those traders, back-testing can prove useful. If their back-testing suggests a trade isn't viable, then they shouldn't trade that trade. Live trading isn't going to work better than back-testing, so they can rule out some trades or adjustment practices.
We traders come in all types. However, I respectfully beg to differ with the pundit who supposes that back-testing does nothing to help with the emotions of trading and may in fact be harmful. Used the right way, the practice is useful. Make your own decision about what works for you.