How to backtest option strategies? What are the best strategies for backtesting?
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- Updated On:02-Apr-2024
- Replies:2
Short Answer
Option strategies are of many types and a trader can alter those strategies to any end number of combinations as per his/her needs. There are software like Opstra Define Edge & Sensibull that allows to make Option strategies and backtest them run then in real market conditions. The Strike price, quantity, IV (Implies Volatility) can be changed in Opstra that allows the trader to backtest any Option Strategy or modify it according to their needs.
Detailed Answer
Option Strategies-
Option strategies are a combination of 2 or more Call and Put option that is bought or sold at the same time for a same underlying asset.
There are many types of Option strategies, Some are Naked, some Hedged. Some involve Option buying, some involve Option selling and some involve both.
Option buying is like buying a Lottery ticket, where the chances of winning Big is very little. On the other hand, Option Selling is considered as a steady business in which the chances of winning Huge is not there but the chances of making steady money are there.
Buying or Selling options make in a Naked Option strategy where the trader makes a profit only when his anticipation is right or else he might face a loss. Naked option strategies can be used only for a Directional view.
To cover these shortcomings of naked options trading, one used more than 1 Option is used to form a Strategy that can be deployed in every type of scenario, be it Bullish, Bearish, or Neutral.
Some Option Trading Strategies are-
- Long & Short Straddle
- Long & Short Strangle
- Bull Call Spread
- Iron Butterfly
- Iron Condor, etc.
All the above options strategies are multi-leg option strategies that involve more than 2 option contracts.
For Example, the Iron Condor uses 2 ATM (At The Money) Call & Put options and 2 OTM (Out of The Money) Call & Put options as a hedge to prevent from the unlimited risk involved in Option selling.
Similarly, Every Option Strategy has the 3 main aspect-
- OTM- Out of The Money
- ITM - In The Money.ATM
- ATM- At The Money
These factors determine the overall profitability and the overall risk factor of any option strategy.
These factors can be altered by traders as per their convenience and requirements but the End result is affected while changing these factors.
Backtest Option Strategies-
Backtesting is one of the most important parts in formulating options trading strategy. In simple words backtesting means- checking the historical data to analyze the potential of a stock, profitability, its volatility. There are plenty of platforms that allow backtesting like TradingView, Quantsapp etc,.
There are many conditions in setting rules that include option contracts, strike prices, expiration dates, ATM options and others. After backtesting you will learn whether or not your strategy is worth it or not. The conclusion of this will tell you the effectiveness of the strategy you made.
To Find out how the total Profitability and total risk changes by shifting Strike prices of an Option, One needs to backtest the strategies by applying their required Strike prices,
This can be done in multiple software that is available for free, but the most commonly used is Opstra Define edge and Sensibull, where you can seamlessly create option strategies and backtest them.
In Opstra, One can add various options to form your own Option strategies or modifies the Strike prices and Number of Lots in each Strategy.
For Example-
In an Iron Condor-
1 Slightly OTM(Out of The Money) Call and 1 slightly OTM Put option is Sold and
1 OTM (Out of The Money) Call & 1 OTM Put is bought.
In this strategy, the maximum profit is got when the underlying asset expires someplace in Between the Sold Call & Put option. Now if the Trader wants to Choose a Farther or nearer Strike Price, they can adjust the Strike Price in Opstra and it will automatically show the Breakeven and the total Margin required along with the maximum Profit & Loss.
It will also show the Difference in the Payoff Graph.
Let's take Nifty as an example and apply an Iron Condor-
- In the First case the iron Condor has been set and the Options that are bought are around 200 points away from the Option Sold. The result is shown in the Graph Below.
2.Now if the Hedge is Shifted another 100 points, the following difference can be seen below-
As visible above the total Profit changed from 4700 to 7900. The Total Credit changed from 4713 to 7995 and the total margin increased by 10,000 in the latter.
In this way, a Trader can backtest various options strategies along with tweak the Strike prices and other factors based on their requirements.
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Discussion (1)
If you're looking for a straightforward and comprehensive take on options trading, then Sensibull should do the job perfectly. However, if you're and expert and want more complex trading tools, then Opstra is the one to choose.
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Backtesting Options strategies in Sensibull and Opstra are almost similar but Sensibull has some added features like implementing the strategy directly from your broker's terminal, etc. However, you'll have to subscribe to a paid plan in Sensibull to access the features, whereas it is free to backtest options strategies in Opstra Definedge.