What Gives You the Confidence to Follow Your Process?

Is it constant backtesting, or an overriding believe in compounding edges?

Disclaimer: I wholeheartedly value backtesting. I think there is tremendous advantage to be gained by getting a complete sense of what is possible, and the drawdowns and hiccups one should expect to see during the lifetime of engagement in a strategy.

Now with that disclaimer out of the way, I’d like to share my frustration in backtesting option spread strategies specifically.

Anyone who has ever worked a complex 4-legged option spread order at mid-price for an entire day knows what I’m going to mention here. How many times, for example, have you placed an order to sell a spread at the mid-price (the theoretical value) only to watch that order sit unfilled for hours? And then how many times have you degraded the price you’d be willing to accept for the fill, sometimes 5–10 cents cheaper than the mid-price, and STILL struggled to get a fill? If you trade like me, it happens often to you. Heck, earlier this month I was attempting to close a profitable Iron Condor trade (4legs — one long put, one short put, one short call, one long call) in FXE (the Eurocurrency ETF). My bid to close the trade was 10 cents better than the mid-price for FOUR DAYS before I got my fill.

Now, as annoying as getting these fills may be, it comes with the territory and it doesn’t bother me that much. But how do you model for that in a backtest? How does your backtest account for the fact that it might be impossible to actually get a fill at a theoretical value? How does it model for the fact that you had to crater your price 10 cents below theoretical value to get a fill? How does it model for the fact that your test thinks you should have been in a trade for 16 days, but in actuality it took you two days to get filled on entry, and three days to get filled on exit? These are extreme examples, but anyone who has traded option spreads long enough knows it happens.

The genesis for this rant was a recent guest I had on the Gimme Some Options podcast. I had the pleasure to have options trader John Wilson on to chat about his process and how he approaches his trading on a daily basis. We had a wonderful and wide-ranging conversation that will be illuminating to anyone considering a career in options trading.

“I love this game. It’s the most fun I’ve ever had. But to be successful, you have to keep it mechanical — slash — boring.…unfortunately.” ~ John Wilson

Obviously, we chatted about backtesting strategies and John had some insightful ideas about ways to approach building backtests as well as evaluating and interpreting the results. This segment of the convo stands on its own as well worth your time.

We also chat about ways in which he attempts to balance his portfolio across different strategies and we observe and enjoy the fact that he and I both have similar aims and often end at similar results, yet the two of us take very divergent paths to arrive at our final destinations.

Further proof there is no ONE WAY to profitably trade — in options or anything.

For a great listen during your commute home or your evening walk, check out my interview with John Wilson:

The Gimme Some Options podcast recently launched! It’s a mostly daily broadcast which dives into the options trades I made each day and why, as well as occasional interviews with other options traders. I seek to learn from everyone and share stories that will educate, enlighten, entertain, or scare you right out of your pants.

Archives are available on Soundcloud and you can subscribe on iTunes.