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What benchmark should I use for backtesting a model for when I should buy an option of a particular stock? For equities, one could say their portfolio outperformed the S&P 500. I would like to have a similar means of comparison for trading stock options. The only thing I've been able to find that I think is appropriate is the VIX. Is there a better or more appropriate way to do this, so I can see how my portfolio and strategy performs in a backtest?

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3 Answers 3

up vote 4 down vote accepted

The best solution in most cases where one is backtesting from a non-standard universe is to construct your own index. I believe that to also be true in your case, as there is no standard index tracking the returns of a particular basket of options. VIX, in particular, is more accurately thought of as a price index, not a return index, in the options world.

To construct your own index for a long-only strategy, just take the entire universe available to your strategy and find the returns of a market-value-weighted portfolio of every security. If your strategy is both long and short, the correct index is cash. The market value you use is a bit subjective, as you could use either the market value of the underlying stock or the open interest of the options.

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Okay thanks for the explanation, I didn't think it would be that straightforward. –  eWizardII Jan 17 '12 at 2:35

When testing your strategy, what you need to pay particular attention to is performance attribution, in other words why did you see the returns you did?

Let me give you a simple example to illustrate what I mean. Suppose I have an algorithm to pick stocks and you have a testing database of stock prices for one year. Suppose also that in that year the market was down 15%. You test my algorithm and find it returned -2%, beating the average by 13%. Is my algorithm a good one?

Now suppose I told you my algorithm was to take your money, charge a 2% management fee off the top and leave all the cash in a non interest bearing account. Does it sound as good now?

The question then is not if a strategy differs from a benchmark index, but rather why?

It could be because:

You selected from a different universe (comparing US equities to the DAX for example).

The risk profile of the stocks you selected differs from the universe (picking only low price stocks out of a universe of all stocks).

Your "universe" differs from the universe from which the index was constructed. For example suppose you select a test dataset consisting of all the NYSE stocks on Jan. 1, 2011 and collect returns for 2011. This would differ from the NYSE index simply because new stocks are listed during the year which were not there on Jan 1, the day you fixed your universe.

Even if these sort of technical factors are fully accounted for, there still remain many great questions for which you would like to have insight. For example if a stock portfolio does well was it:

1) Invested in the right sectors, but underperformed in those sectors?

2) Invested in the under performing sectors but picking the high performing stocks in those sectors?

3) Some permutation of the above?

Bottom line: don't just compare to an index.

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Thanks for the insightful information. –  eWizardII Jan 17 '12 at 2:33
    
I presume that this is where the risk-free interest rate comes into play, so the standard benchmark would be to compare your performance with the risk-free interest rate and see if you can beat it. The more circumstances you can beat it in, the better your algorithm. –  Lirik Apr 17 '12 at 15:00
    
@Lirik - The concept of a "risk-free interest rate" is an illusion. All assets have risks, such as risk of inflation, theft, war etc. –  JonnyBoats Apr 17 '12 at 16:14
    
Of course the "risk-free interest rate" is not really risk-free, but it's commonly referred to as such. I was just asking if that would be a good universal benchmark to test against. –  Lirik Apr 17 '12 at 16:54
    
@Lirik - it really depends on an individual's or institution's investment objectives. When a professional investor gives a money manager funds to invest he will define the benchmark for the manager. So when a large university gives a money manager funds to invest in the US equity markets they might use the S&P500 as the benchmark. Funds given to an investment firm in Europe might use the DAX. It would be highly unusual to give a fund manager investing in real estate in Japan a benchmark of the risk free rate for Swiss francs for example. –  JonnyBoats Apr 17 '12 at 18:40

I have a bit of experience backtesting options. I would love to know a benchmark applicable to all stocks. Unfortunately, it might now exist, IMHO. Each stock has own benchmark for position entry.

Using Oscreener tool, I discovered that most stocks with strong fundamentals have cyclical performance in upward direction. Sometimes 20day Moving avarage = down is a good sign for position entry with some stocks and some other times 20 day MA - UP is a good sign to enter the market for some other stocks.

Note, I am a directional trader and mostly use Calls when volatility is below the average to avoid any risks. Hope this helps in your findings.

Good luck!

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