The question comes up every now and then: How do you backtest an option trading system? When you create an automated trading strategy, you first need a set of rules to guide the entry and exit of a position. The most important part of this being “what position are you going to trade?”

When Do You Buy or Sell a Stock Option?

For a stock, there is an easy answer—you can only buy or sell the stock. However, when it comes to options, this becomes more complicated. Now you must answer the questions: Are you going to buy or sell? Are you going to use a call or put? What strike price and which expiration do you want to use? Does that particular option have enough volume to be valid, and will it have enough volume when you go to exit the position?

To get started, look at something as simple as stock price. Your system parameters can tell you to buy a stock at a certain price—say $50.25. If you translate this into an option, it may only have a $50 and $50.50 strike, so which one do you choose? Before you answer this, remember that each one of these option strikes has its own price, so instead of just knowing the stock price, you also have to determine which option price would best correspond to that stock price or entry price.

How to Analyze Stock Option Volume

Now take the above example and apply it to option volume, which can swing wildly, or option expirations that can range from days to years. With expirations, you have now added a time limit that, in some cases, does not pertain to buying or selling a stock (as a stock usually does not expire).

If we start looking at indicators for our trading system, the same will hold true. The indicators used to determine when to buy and sell a stock are different from those used for an option – which can further increase the complexity of your trading system.

Developing Market Specific Trading Strategies

The other point people tend to forget when creating a trading system is that, in general, there will be times when the system works, and times when it doesn’t. Trading systems have a tendency to favor one type of market; for example, some systems work great when the stock is trending up or down, others work great when it is volatile, others when it is calm. But very few, if any, work in every type of market.

In general, people are great when their system is working and making money, but what are you going to do when your system is losing? Do you shut it off, trade a smaller size or do something else? You must be able to answer the most important question: in which markets or conditions does your system work best? Most people know what conditions they want it to work in (mainly all markets), but when they really analyze it, they find they still haven’t answered the original question. But in reality, it is only when you become frustrated with that question that you are on your way to creating a great trading system.