Cracking the Code: Backtesting Insights for Options Investors

In this episode, we dive into the world of backtesting with Matt Amberson, Principal at ORATS, to uncover how data-driven insights can optimize options trading strategies. Learn how backtesting helps investors navigate uncertainty, refine entry and exit points, and predict future performance with greater confidence.

Summary – IBKR Podcasts Ep. 210

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson 

Welcome to this IBKR podcast. My name is Andrew Wilkinson, and in this episode, I’m going to be chatting all about backtesting option strategies. My guest is Matt Amberson, who’s the Principal at Option Research and Technology Services, or ORATS for short. Welcome, Matt. How are you? 

Matt Amberson 

I’m doing great. Great to be here. Good to see you. Let’s get to my favorite subject. 

Andrew Wilkinson 

Let’s get underway. Can you explain for the audience, in a nutshell, what does backtesting involve, please, Matt? 

Matt Amberson 

Yeah, definitely. I mean, we’ve had data forever at ORATS, and people go, how do you know that your data is good? How do you know that it works? I go, well, let’s put a backtesting platform together. And so, in a backtesting situation, you simulate a strategy that you want to trade. Let’s say short a put spread. 

And you say, okay, I’m going to short this put spread every time this happens, this entry criteria, and then I’m going to see how it does. And we do things like we have very clean historical data. We have trading assumptions, and all is important to do, cause you need to—we call it slippage. 

And you might know it as just crossing the bid-ask spread. And then we also have commission assumptions in there, and we then go through and pretend we’re trading. So, backtesting is a cheap way to see how you’re going to do in a particular situation, Andrew. 

Andrew Wilkinson 

Okay. And how does that help the investor, and particularly the options investor, Matt? 

Matt Amberson 

Yeah, well, it saves them some money often. But mostly what I like is it shows people what to expect from a particular trading strategy. And also, what is the difference between trading? There are so many decisions now, like all these days to expiration, all these different strikes, which ones could you possibly choose? 

And no, well, backtesting could help you on that. And of course, the past doesn’t always reflect the future, but it gives you a pretty good rhyme of it. And so, backtesting helps you by having you see what comes out historically, and as an investor, what are my expectations? What are the things I’m looking for? What do I want to accomplish by using options? And that’s what backtesting can help with. 

Andrew Wilkinson 

So, help me out a bit here. What’s the critical element? Is it testing to find the best strategy, or is it testing to find the best entry or exit points? 

Matt Amberson 

You ask the hard questions, Andrew. So, I would say what you’re trying to do is make a successful trade in the future. And so, with incomplete and inaccurate, sometimes, knowledge about what is going to happen, you have to use a backtest to inform these decisions placed in uncertainty. 

And so, what’s critical about backtesting is you want to get as much information as possible. You don’t just say, I’m going to find the best one that’s overfit and did the best. What you want to do is dig deeper, really work at it, compare other symbols, or maybe, or do other techniques that can help you predict and have the best future tests. You don’t want the best backtest. You want the best future results. 

So, that’s the critical part, and that’s difficult. 

Andrew Wilkinson 

Can you apply backtesting across all symbols, or even across all markets, or do you need to test symbol by symbol? 

Matt Amberson 

That’s part of the critical point, is that you want to find something that doesn’t just work for one particular symbol. You could get similar symbols, and then another similar symbol, and then a different symbol and understand why a strategy works with one and doesn’t with the other. 

And when you could start to explain all that, you’re really learning about the crux of the situation and what needs to happen in the future for you to be successful with your option investment. And yes, definitely want to test it over many symbols. We have ways in our design of our backtesting to say, okay, make it easy to take all these different assumptions and put it on a different symbol. See how that did. Okay. 

Then go in and say, what if I adjust this thing? How well does it do? So, all of those are very important in order to predict and try to come up with the best performing strategy in the future using those techniques. 

Andrew Wilkinson 

Where have you found that the backtesting kind of really lights up the room? What works well? 

Matt Amberson 

I think the coolest thing, and I learn things all the time. I’ve done millions, hundreds of millions. I mean, we have 181 million pre-run tests on the Interactive Brokers platform right now. So, I’ve done those times 10. So, I’ve seen so many backtests, and I always learn something. But what are the coolest things I’ve learned? 

And I used to be a market maker, and I kind of had this in the back of my head. So, I had these theories, and I could prove them out. But one of the neat things that, like a rule of thumb that I’ve now learned is, when the volatility is really high and it seems like it’s really high, you might be tempted to sell it. 

But really, what I’ve learned in backtesting is there’s a kind of something keeping implied from going to even the correct heights when it gets really high. So, I’ve come up with a theory like they don’t get the IV as high as they should when it’s high, and they don’t get it as low as they should when it’s low. 

So, that’s like just one of the many kind of rules of thumb and neat things that you learn from backtesting is like, oh, even though it’s high, doesn’t mean sell it. It actually means it could be the opposite. It could mean they’re not getting it high enough. So, those are some really neat things to learn from backtesting. 

Andrew Wilkinson 

And have you stumbled across things that just don’t work? 

Matt Amberson 

Well, I mean, I think when I’ve had my least success implementing some of these strategies, it’s when you take the lazy way out. Backtesting is not lazy, and if you’re going to make it work, you’re going to have to really work at it, meaning do some of the things that you brought up before—testing different symbols, testing different days to expiration, testing different strikes to use. 

If you really get into it and really measure it, you’re going to do well. But if you just take the lazy way out and go, oh, this is the top of your 181 million tests. I’m just going to use that. I could tell you that’s probably the most overfit. 

One of the no-nos of backtesting is you want to find something that works in many different situations. That might be a starting point, but that’s not an ending point. So, when you just are lazy, choose the top one without really testing it, those are where I get in trouble, Andrew. 

Andrew Wilkinson 

Matt, I think you could spend hours playing with this software. Would you say it’s of equal value to both new traders new to options as well as to those who have been trading options for years? 

Matt Amberson 

Everyone can get something out of backtesting. I learn things, and I have been doing this, you know, fifteen years. And thanks. Thanks for being one of the listeners. And I know you’ve been on the show for several months. You’ve been getting some great stuff going in there on the web. 

But I also know that you’ve been doing some great things right now. It has some aha moments often. And I mean, you should—the greatest thing for having a company like mine is hearing from these guys. It just accelerates and just gets them so thrilled to be able to understand what’s going on. 

Whereas before, I remember the first day on the floor, I went around and I said, what are all these numbers? What is going on? And when you start to get it, you go, ah, you walked out, and you go, I get this now. Backtesting does that for people, and there’s nothing that makes you feel better than when someone just writes this glowing email and says before I was a newbie, and now I feel like I understand at least part of what’s going on in the options game out there. 

Andrew Wilkinson 

For the listener, the ORATs backtesting software is available to IBKR clients at no cost in the Discover section of Trader Workstation and the IBKR mobile app. 

And Matt Amberson, thank you very much for joining me on this IBKR podcast. 

Matt Amberson 

Thanks, Andrew, it was great. 

Andrew Wilkinson 

And as a reminder to our audience, if you like what you heard in this episode, please do remember to subscribe to our channel from wherever you download your podcasts. Thanks, everybody. Bye for now.