Nov 16, 2020
6 mins read
Wouldn’t it be great to see the future? To see where turning points in price will occur with a high degree of accuracy? To see if a trading system that you developed or bought or learned actually works? Well, you can, with a method called BACKTESTING.
Backtesting performs three important functions:
1: It helps you IDENTIFY the reliability / win rate of your trading system over time.
2: It helps develop and reinforce the muscle memory you need to EXECUTE opportunities in your trading strategy
3: It helps you continually REFINE / improve your strategy as you observe it work against price action, ultimately increasing your "hit rate" as a professional trader.
The first requirement of a trading system is that it works via RULES. There are no 'hunches' in the market... the market has specific behavior patterns and our job as traders is to recognize those patterns and capitalize on them.
Backtesting has three important requirements:
The first requirement is that your trading platform supports backtesting. Can you go back "x" amount of time and look at the timeframe(s) you need to make the decisions you would have made if you were "in the moment" in an efficient manner in order for you to simulate hundreds of trade setups?
The second requirement is that you are willing to put the energy and work into testing your trading system within an inch of its life before you risk a single penny of your trading capital. You need to know WHEN the system works, WHERE the system fails, and WHY the system worked and failed when it did, and that takes hundreds (if not thousands!) of simulated trades to do so.
As you are observing the system in action you will begin to "see" the patterns in a new light. It will become more and more intuitive and you will find opportunities to 'tweak' the system as you go along. You will identify patterns when trades fail and stop trading that pattern. You will see opportunities that got away and you can 'tweak' your system to take advantage of those opportunities. Most importantly, you will see whether the system even works reliably at all and ditch it if it doesn't. It may be frustrating to decide to do so, but the good news is you will not have lost a single penny trading a faulty system to begin with!
TRACKING YOUR TRADING SYSTEM
To track the accuracy of your trading system you will need to setup a spreadsheet that will record the important variables you want to track. For example, you may want to include the headers,
Asset / Date / Time In / Time Out / Long or Short / Reward to Risk Ratio / Gain or Loss / Account Balance
The "Reward to Risk Ratio" column is the most important. If you read my previous column, "Trade Like a Pirate" I discuss that you need to think in terms of Percent Risk per trade ("R") and not Dollars. This will show you how well your strategy works. For Example, if after tracking 100 trades you find out that your system has a 33% success rate, your account will grow by 1% for every three trades if you follow a minimum 3:1 Reward to Risk Ratio (3 -1 -1 = +1). If you find on average 6 trades per day, your account can potentially grow by 2% per day. Under the "Account Balance" column, if you add the trade's win/loss to your previous account balance you can determine how long it would take to get 'x' amount of money from where you started (or how long it will take and inferior system to lose it all as well!)
Testing your trading system also shows you how many opportunities present themselves per day / per hour and when the best time is to go 'fishing' for trades. Backtesting might tell you that you need to wake up 2 hours earlier (and go to bed 2 hours earlier) if you want to achieve the goal of replacing your car in 6 months. Or fire your boss in 24 months. Or pay off the mortgage in 3 years. Having a plan to make money should also include your plans on how and when you want to spend that money - how you will 'pay yourself'.
Socrates famously said “The unexamined life is not worth living.” Likewise the unexamined trading system is not worth putting your hard earned money into. The more you backtest your system, the more you will gain (or lose) confidence in the system which will ultimately determine the actions you will take.
Another happy by-product is that not only will you be able to refine your trading system, but you yourself will be continually refined in the fire of the market, exercising your mental muscles looking for opportunities that meet your particular trading system. For instance, by analyzing all my losing trades in my first batch of 100, I was able to identity a pattern in the formations common to all failing trades but not winning trades. I then modified my trading system to exclude trades which showed that pattern, increasing my success rate by 30% in the next 100 trades I tested with the new system. Not happy with that, I went through my losing trades from Round 2 and found another common pattern among them. Eliminating those, I modified my system and increased my success rate by yet another 20%.
Finding what works is often a product of finding out what doesn't work, and just stop doing that!
If you need advice on how to stop a bad habit, just listen to Bob Newhart:
Finally, just as any athlete will you tell you that you should "Warm Up" before performing any strenuous exercise, one thing my backtesting system has taught me is that I need to spend the first 30 minutes of my trading day "warming up" by finding all the opportunities that presented themselves in the Futures market during the overnight session and log them in my spreadsheet. Likewise at the end of the day I look at all opportunities I might have missed so I can reduce the likelihood of missing them again. The original title of this article was "Backtesting to the Future" which reflected this habit: by 'warming up' before actually trading I got my mind prepared to "see the opportunities" for the future day ahead, and I identified these patterns a lot better than I would have if I entered the pool cold and experienced the 'cramp' of a losing trade.
Admittedly, backtesting a highly visual concept, so I will be following up this article with a video showing an example of my backtesting strategy and how you can model my system to meet the needs of your system. As I love to say, "Good artists copy, great artists steal." Likewise, "Good traders copy... Great traders steal." I hope you can steal some of these ideas and have them help improve your trading game!
Share your thoughts and success below! As always, I'd love to hear if this has helped you become more confident and profitable in your trading. Like and Follow if you haven't already and you will be alerted to when I post the followup video!
Trade hard and trade well!