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What is your process of transferring an options trading idea into trading system/plan

Discussion in 'Options' started by runmael, Apr 5, 2016.

  1. runmael

    runmael Member

    How do you come up with a (hopefully) profitable trading system (set of rules for executing strategy) from the initial idea? I would like to learn more about this process of creating trading system/plan, so I would be thankful if anybody is willing to share his methodology. Thanks :)
  2. Paul Demers

    Paul Demers Well-Known Member

    That is a very personal journey and I can only relay what I do when I am designing a trade.

    I determine a few things in the beginning: the trade, the timing (starting DTE and the duration), the underlying and the maximum amount of risk. Then I start back testing the trade using a one year period that would show me how the trade would react to both upside and downside events. Looking at SPX it seems that using 2012 timeframe would do. The initial testing is done as a no touch as I want to see all the weaknesses of the trade itself. I will record what the trade does every day. I track the P/L, the position deltas, the daily moves in the underlying including high and low for the day, the IV of the position strikes, the IV of the ATM strikes and any other data that I think is relevant to this trade.

    This becomes the benchmark to use to develop an adjustment strategy and compare the new testing. Using this data helps develop the adjustments and timing of the adjustments that will be used. I will try to come up with several adjustment strategies from the data.

    I identify the trades that got in trouble and go back and retest those time frames using each adjustment idea to see which one was the most effective. I know that doing that particular time frame over and over that there is a likelihood that there will be curve fitting. What I am looking for is what adjustments are effective. I will keep all that work at this point as one may be better than another in different environments.

    Now that I have a list adjustments in hand I look for the nastiest periods in the market, such as the 2008, 2011 and 2015 drawdowns as well as when the market had sharp upturns to stress test the trade using all the different adjustments. If the trade has survived then the next step.

    I generally start testing in 2009 and go to the end of 2015. Generally I just record the end of day data and if I need more data for a particular trade I will record the daily data. This testing gives me a better overall look of how the trade is behaving. Because this gives a fairly small sample set (12 per year) I will change the DTE entry and back test at least three more sets of data.

    While the back testing gives a sense of how the trade is going to perform it also gives me feel for the trade. If the trade meets expectations the next step is the “test kitchen”. This is where I will put the trade on live and spend the next six months babysitting it (watching the trade all the time) I want to see how it behaves live. I do not paper trade as it is very different than live trading and I want to know how the trade works and how my emotions work during the life of the trade and there is no other way than putting real money on the table.

    I know I am leaving things out and would be happy to answer any questions if I can.

    Hope this helps

    Trader G, Shin, dacamon and 6 others like this.
  3. runmael

    runmael Member

    Thank you Paul for such a thorough answer! It is a very interesting process, but it all makes sense.

    What do you mean when you say that the initial testing is done "as a no touch"? Do you use some services / tools somewhere in your process, how do you track P/L and greeks? Thanks!
  4. Paul Demers

    Paul Demers Well-Known Member

    I will take the initial trade setup and back test it with no adjustments. I want to try to determine where I would have to make an adjustment to the initial trade. I just take notes to track ideas and concerns at this stage. While I have done some programming to automate some of this process I like to manually back test a new strategy. You will never get a feel for the trade using automation.

    Hope this helps
  5. runmael

    runmael Member

    Yes, that sounds logical - thank you for clarification. The only thing that I am unsure about is how do you backtest manually? (do you use some tools from it, from where do you get data). Thanks!
  6. vega4mike

    vega4mike Well-Known Member

    Optionvue, OptionNet Explorer, there may be others, but these I the ones mainly used by most traders here.
  7. runmael

    runmael Member

    Hi, thanks for the reply. So, just to be clear, those tools have the feature to manual backtest your strategy (manual vs automatic)?
  8. vega4mike

    vega4mike Well-Known Member

    Manual, optionvue have a 14 day trial, so you may want to check if it meets your requirements.
    runmael likes this.

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