Backtesting on historical option data

Question

I have downloaded some daily historical option data for a timespan of 10 years and want to perform trading backtests with them. Data are European index options, on ODAX. My question is about realistic assumptions on backtest fillings:

a) valid bid/asks: I would assume the mean of bid and ask as filling price

b) bid and ask=zero: This happens mostly for some of the ITM options, the underlying beeing more than 300 points away from ATM-strike. Not sure what to do: my idea - market maker has to take counterparty, so I assume realistic quotes and realistic bid ask spread and again mean of bid and ask.

c) bid and ask unrealisticly high/unrealisticly low: happens both ITM and OTM, same procedure as in b)

Are those realistic filling rules? If not, how should the rules be?

Answer 1

The mean of bid and ask for a fill is not realistic and this will impact your analysis a lot in options. The market maker is quoting the spread because that's how they intend to get paid for the risk if you bring them one leg. Use the worst pricing assumption on this, even though you should probably still rest orders in practice for anything that has a spread of significance.

Option Spread Trades
If you bring a spread trade with lower risk then market maker is more likely to do business inside of the bid/ask spread. If the market maker sees you resting an order and has an opportunity to spread (risk management options position type spread - not bid/ask) your trade against somebody else resting in the book then they're also more inclined to do business inside of the bid/ask spread.

Market Impact
If you go with size (what size is depends on liquidity of the products you trade, but it can be surprisingly low in some 'popular' products) in one trade or a number of trades then market makers in the product will adjust implied volatility in response to order flow. This means that good prices for establishing your position will be getting away from you.

More Data is Always Better
Try to get trade and quote data or at least get trade data where quotes are included at trade time. This is a lot of data and it's never cheap. But options are complicated and the liquid markets are very well arbitraged.