#796 - Why Is Backtesting Important?

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we’re going to answer the question, “Why is back-testing important?” I actually get a lot of pushback on this and I think that many people look at back-testing as irrelevant and I think that back-testing has a lot of relevance if you use it correctly. Sure, back-testing is not perfect in the sense that a perfect back-test is not going to be the perfect expectation of what we should expect moving forward in the future. Obviously, what happened historically is not going to happen the same way in the future. We should all know this. This is a rational logical thought process that we should follow. But a lot of people think that when we say that something is going to back-test and win 70% of the time that it will exactly win 70% of the time in the future. We know this is not the case, that the future is still out there, it is unknowable, it is unpredictable, but for me, back-testing gives us parameters, bumper lanes if you will from which we should start to develop a guidepost to work towards. Now, does this mean that we have a back-tested strategy that we will exactly use just like that moving forward in the future? Definitely not because in some cases, we see that one particular back-test might just randomly be at a time period where it’s got a lot of high profitable trades. And so, it could be at the top of a peak in a series of peaks and valleys. What we look for in back-testing is we look for congruency and for clustering of performance around different metrics. And so, again, this gives us an idea or a frame of reference on guidepost, on rails, on bumper lanes, whatever you want to call it, so that we stay out of the sand traps on either side. If I know in back-testing that generally, 30 days performs better than 50 days, okay, great, that gives me a guidepost to say that we should generally enter trades around 30 days and 60 days, but maybe try to scale back the entry at 50 days. Does that mean that 50 days doesn’t work? No. It just means that 30 days or 60-day entry periods might work a little bit better and that might be on a wide breath of different strategies and ticker symbols and different expiration contracts and puts and calls and short strangles and straddles. We might see this clustering or this congruence of performance metrics around that type of data point. To me, that’s the value of back-testing. It’s getting you out of those very easy to fall in sand traps on either side of your hopefully trajectory on where you’re going with your portfolio. Well, a very easy sand trap that a lot of people fall into is short Delta short expiration periods and long calls and long puts, trading these very cheap, very close to expiration, a week or two out from expiration long calls and long puts, little lottery tickets and it’s a very easy sand trap to fall into because we know from a lot of testing that they just flat out do not work. There’s no rhyme or reason necessarily as to why they don’t work. They just don’t. In any market environment, in any time period, most of the durations in Deltas that we’ve tested in profit-taking levels or stop loss levels, they just don’t work as well as something else. That alleviates that need to find something in that little small needle in a haystack of things that work. Instead, I would rather just play in a different pool, in a different arena of things that generally work. Am I going to pick the ultimate strategy moving forward in the future? I probably doubt it because I don’t know what the future is going to bring. But can I drive on the right side of the road? Can I be in the right lane? Can I be working towards the right guidepost? I think that’s where back-testing definitely has its value. Hopefully this helps out. As always, if you guys have any questions, let me know and until next time, happy trading.

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