SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

When Can You “Trust” a Backtest?

There are jokes within the financial industry that "nobody has ever seen a bad backtest" and that "the worst 10 years of your backtest are the next 10 years". There certainly are bad backtests, but nobody ever markets them. They just get thrown in the trash. Even academics can fall prey to this.

Although they may not be selling a strategy or investing concept to investors, they do have incentives to get their research published in academic journals that their peers may read and respect. There is also the financial incentive of job security by earning tenure at their university, for it’s“Publish or Perish” as the phrase goes. This means few, if any, are immune from the incentives to create an attractive looking backtest.

Does this mean we should dismiss all backtests? Certainly not, it just means we need a process, or series of scientific tests, that we run all our backtests through in order to keep ourselves out of trouble and from falling prey to good stories told by good salesmen. I must give credit where it’s due here. Both Dimensional Fund Advisors and the books and writings of Larry Swedroe have influenced my thinking when it comes to this topic.  For those who want to go deeper, I recommend reading Larry Swedroe’s book, “Your Complete Guide to Factor-Based Investing.”

The 5 characteristics to look and test for when considering investments are:

  1. Persistent across time. The strategy or factor can be tested on long periods of historical data to increase statistical confidence. Larry Swedroe often points out that the average investor thinks three years is a long time, five years is a really long time, and 10 years is an eternity...yet if you ask academics, they will tell you that 10 years is nothing more than random noise that likely should be ignored. For example, the S&P 500 returned -1% per year from 2000-2009. Would that have been a good indication of long term expected returns for buying large cap US stocks? Since then, the S&P 500 has compounded at more than 12% per year, which is better than its long-term average. This is similar to how in August of 1979 BusinessWeek wrote a cover story called “The Death of Equities” after the S&P 500 had experienced a similarly long period of poor performance. The S&P 500 went on to compound at more than 17.5% annualized for the next two decades, turning $100,000 into more than $2.6 million.
  2. Pervasive across markets and geographies. The strategy or factor holds up when tested on other markets and countries. For example, the momentum effect has been found to exist in stocks, bonds, commodities and currencies. It’s also pervasive across sectors and in the historical data of nearly every country.
  3. Robust to various definitions. An effect should still show up when constructed with similar parameters. For example, the value effect is both persistent and pervasive as well as robust to alternative specifications. Whether it's price to book, price to sales, price to earnings, price to dividends, price to just about find in the historical data that value stocks (low price relative to fundamental measurements) outperform growth stocks (high price relative to fundamental measurements) over the long term all across the world.
  4. Investable. The strategy exists not just on paper but survives real world issues such as manager fees and realistic assumptions for transaction costs. Many anomalies discovered in the historical data persist simply because they are difficult to implement at size in the real world. Academics refer to this as "limits to arbitrage,” where an anomaly persists in the data because it's difficult or impossible to actually implement at scale and therefore it’s really only a paper illusion.
  5. Intuitive. Does the strategy make intuitive sense with (preferably) a simple risk-based explanation or,at minimum, a logical behavioral based explanation? For example, the market factor (stocks producing higher returns than T-bills) has persisted for decades even though it's as "well known" as any factor there is. Since everybody knows about it, why doesn't it get arbitraged away? One rational answer is that you simply cannot arbitrage away risk. Not only do stocks occasionally underperform cash over 3, 5, and 10-year periods, they can do so by A LOT (S&P 500 example in #1). The same is true of all other academically accepted factors like size, value and momentum.  For this reason, investors who have a sufficient time horizon and temperament can consider tilting their portfolio towards these "open secrets" that have a long history of producing higher than market returns.

Now, which factors pass all five of these tests and therefore are eligible for inclusion in our client portfolios?

  • The market factor (stocks have higher expected returns than cash and bonds). Risk based explanation.
  • The term factor (bonds with longer maturities have higher expected returns than bonds with shorter maturities). Risk based explanation.
  • The size factor (small caps have higher expected returns than large caps). Risk based explanation.
  • The value factor (value stocks have higher expected returns than growth stocks). Both risk and behavioral based explanations.
  • The trend/momentum factor (stocks and asset classes that have outperformed over the last 6-12 months have near term higher expected returns than stocks and asset classes that have underperformed). Behavioral based explanation.
  • The volatility risk premium factor (also known as the insurance risk premium…selling financial insurance in the form of puts and calls has positive expected returns). Risk based explanation.




When investors understand the concepts discussed in this article, your investing life will never be the same. Using this checklist dramatically improves the odds of success and can keep investors from falling prey to a good sales pitch or chasing a good looking backtest that is unlikely to persist going forward in time on a net of all costs basis (transaction costs, manager fees, and taxes).

The real opportunity now becomes the portfolio construction process. We know that the pursuit of traditional active management is largely a waste of time and money, because any manager or backtest performance can be largely explained by exposure to these well-known factors that can now be accessed at low or at least fair costs. These factors discussed have low correlations to one another, so diversifying broadly across them dramatically reduces the risk of your total portfolio. So much so that modest amounts of leverage may be appropriate for those with the patience and perspective to seek higher expected returns.

The biggest risk of a portfolio diversified by factors becomes more behavioral, where your portfolio will at times perform far differently than conventional market benchmarks that are only exposed to the single factor of market beta. Since the only purpose of investing should be to achieve your long-term goals with the least risk, this should be an acceptable trade-off for a well-educated and well-behaved investor.


Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.



What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles


  • Realistic Expectations: Using History as A Guide

    One of the biggest challenges I come across with the typical investor is maintaining realistic expectations and being able to properly understand the tradeoffs between risk and return. We all want high returns with low risk and there’s no limit to the efforts we’ll make to find it.

    By Jesse,

  • CAPM As an Alternative Option Pricing Model

    Options traders endlessly debate the merits of the Black-Scholes pricing model. Some swear by it and others don’t even try to use it. Given the many profound flaws in the model, it is not an accurate tool for developing a sense of where price is likely to move in the future. But there are alternatives.

    By Michael C. Thomsett,

  • Option Payoff Probability

    Options traders must, naturally, be concerned with the likelihood of payoff for a strategy. Ironically, one of the most often cited statistics about profit and loss is simply incorrect. That statistic is captured in the headline of a story posted online “Trading Options: Data Shows That 75% or More of Options Expire Worthless.”

    By Michael C. Thomsett,

  • The Minimum Effective Dose (MED) For Cash Flow Planning

    Financial planners can usually give generic advice that will be appropriate for the majority of Americans, and that’s the goal of this article. If we can get the fundamentals of cash-flow planning right (where to put your money after you earn it and pay your taxes and bills), we’re 80% of the way towards maximizing our financial situation.

    By Jesse,

  • Are You Breaking Even? Or Losing?

    Among the good reasons to trade options is the need to meet or surpass your breakeven yield. This is the yield you need just to preserve your purchasing power; and it higher than most people think. In fact, most people relying on moderate to conservative yields from stocks, mutual funds, real estate and savings accounts might be earning well below this breakeven level.

    By Michael C. Thomsett,

  • Buy When You Have the Money, Sell When You Need the Money

    Money can be quite an emotional topic for many of us. Emotions can enhance our experiences and relationships in many ways, but they can act as mental roadblocks especially when trying to make wise financial decisions. One of the most common emotional roadblocks I come across when working with individuals is an unwillingness to invest idle cash to meet long-term goals.

    By Jesse,

  • Strategy Selection vs. Risk Management

    "A billion here, a billion there, and pretty soon you're talking about real money." Everett McKinley Dirksen. Let’s begin with the bottom line: When I talk to anyone about the concept of choosing an option strategy (or two) to adopt for trading, I stress that the strategy should have certain characteristics.

    By Mark Wolfinger,

  • Blending Anchor Strategy

    Anchor and Leveraged Anchor investors frequently ask why the strategy only trades SPY and SPY options rather than individual stocks, other indexes or commodities. We avoid individual stocks because of tracking and divergence issues.

    By cwelsh,

  • Fundamental Volatility and Stock Prices

    Every options trader must wonder whether any connection will be found between the company's fundamentals and stock prices (and in turn, option valuation as well). Because options are derived from stock price behavior, the analysis of stock movement is crucial to selecting options wisely; and that relies on volatility in the reported profit and loss over several years.

    By Michael C. Thomsett,

  • Bullish Short Strangles

    A bullish short strangle sounds like a complicated strategy, but it’s really quite simple for those familiar with option terminology. A short put is combined with a short call to where the position starts with some amount of positive delta overall. This distinguishes itself from a delta neutral strangle, where both the short put and short call are sold at the same delta.

    By Jesse,


  Report Article

We want to hear from you!

There are no comments to display.

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now

Options Trading Blogs