Option Analysis and Testing as Tools to Learn Options Trading

Options trading systems are approaches based on specific rules for entry and exit moves in relation to an option position. Although many traders use systematic techniques to a strategy (such as buying a call when implied volatility has a relatively low value), a trading system is more complex, with more rigidly defined contours. The article here aims at presenting the general features of such assemblages of rules.

First of all, here are the basic actions one should take when using options trading systems:

  • settle a position for all buy signals generated by the rules;
  • exit each position when the exit signal is triggered.

When implementing any of the available options trading systems, there is no decision-making because you never think about whether to accept an entry or exit signal. In case that something seems to go astray or losses start to accumulate, you have to completely stop the system.

The benefits of using a formal set of trading rules are:

  • it allows one to minimize one’s trade emotions;
  • it enables one to practice backtesting in order to get a sense of expected performance.

However, both of these advantages disappear if you opt to use discretion by deciding which trades to take. Emotions interfere with your sense of action and greatly change your results from the ones obtained during the test phase. Every options trader has a personal way of transacting. Consequently, everyone involved in the related market has to adopt options trading systems that are suitable to their trading style and account size.

Despite the rigidity of the rules that lie at the foundation of such a system, building in flexibility is not impossible and can be done by varying indicator speeds or by adding filters. A filter designates an extra rule for trade entry or exit, whereas indicators and other similar system components are labelled as system parameters.

Good options trading systems are defined through the following characteristics:

  • suitability to one’s style and time availability;
  • stability with manageable drawdowns;
  • profitability when applied to several markets, securities and market conditions;
  • power to diversify one’s trading tools.

Don’t simple create a system and then put it on auto-pilot, remember to always monitor the trades as well.

To determine whether a system generates stable profits, one can resort to backtesting, which uses past data to analyse its proficiency. You can use data downloads and tracking trades mechanically to complete the procedure, but a software application for backtesting is the optimal way to do it. This way, a trader has bigger chances to scrutinize longer periods of time that capture bullish, bearish and sideways moving markets. As a consequence, you will be able to obtain results under worst-case conditions and experience (in the test – created environment) realistic drawdowns. A drawdown refers to cumulative account losses from consecutive losing trades. By assessing them, you manage better your risks.

Recapping, a good trading system functions in a variety of markets ( commodities, stocks, etc.), under various conditions (bull/bear markets). When you review one, look for profitability and stability (consistency of results). You will know that the system is stable if:

  • it has winning trades with average profits which are bigger than the average losses of losing trades;
  • it has an average system profit which is situated near the median system profit (low standard deviation);
  • it sustains manageable drawdowns;
  • it is not reliant on few of trades for profitability.

Once the testing phase yields positive outcomes, you are ready to implement the chosen system. Again, do not forget to monitor the trades yourself. A system is a partner, not an autonomous entity to carry all the trading by itself.

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