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Back-Testing a Trading Strategy

Whether you develop your own trading strategies, purchase a trading strategy or read about a trading strategy in a book, on a website or in a forum, you must test the strategy to ensure it actually works and has a positive expectancy.

 

Here are the reasons why you must back-test trading strategies for any financial market:

 

Reason #1: You must know your numbers

 

There are several important performance numbers you must know before trading a strategy:

 

Total Net Profit:

 

You need to know how much money you can expect when trading a strategy. The total net profit after a given series of trades should obviously always be positive.


Average Profit per Trade:

 

You need to know how much profit you can expect to make on any given trade. In order to get this number, you simply divide the Total Net Profit by the total amount of trades. Make sure that the average profit per trade is large enough to cover your commissions and possible slippage.


Average Number of Trades:

 

You need to know how many trades per day, per week or per month you should expect from your strategy. If you only get 2 trading opportunities per week, then you need a rather high Average Profit per Trade. However, if you get 10 trading opportunities per day, then you might be willing to accept a smaller Average Profit per Day, since you get many opportunities per day. Ultimately the Average Profit per Trade and the Average Number of Trades help you to determine how much money you can expect to make per week, per contract etc.

 

Potential Maximum Drawdown:

 

You need to know the maximum drawdown of your trading strategy. The drawdown is the amount of money that you lose from a high in your equity/account to a temporary low after a series of losing trades, before things turn around again. Typically the drawdown is not caused by a single trade, but by a series of trades during a time, when the trading system underperforms.

 

You need to know the drawdowns that occurred in the past so that you can mentally prepare yourself in the event of a similar run of losses to your account. Keep in mind that no trading strategy produces an up-slopping straight line as an equity curve. Every trading strategy has winning trades and losing trades, meaning you will not only experience winning days and weeks, but also losing days and weeks when trading a trading system does not perform well under certain market conditions. Make sure you are prepared to accept the risk.

 

Maximum Number of Consecutive Losses:

 

When following a trading system or rule based strategy, you must place every trade according to the rules as long as your trading strategy performs within the expected results. If you know that your trading system has produced 8 consecutive losses in the past, then you can't stop trading if you experience 4 losses in a row.

 

The higher the winning percentage, the lower the amount of consecutive losses in a row. However, there are many profitable trading strategies out there that have a winning percentage of only 40% - 60%. When trading these types of strategies, you could experience 8-12 consecutive losses in a row - maybe even more. Make sure you are prepared for a losing streak and keep trading knowing that if you stick with by your positive expectancy strategy you will be net profitable in the end.

 

Average Win:

 

It is good to know how much money you can expect to make on a winning trade. Keep in mind that you are looking at an average win. Some of your winning trades might produce higher profits, and some of your winning trades might result in only a few dollars in profits.

 

Average Loss:

 

If you calculate your average win, you should also calculate your average loss. And as long as your average loss is smaller than your average win, all you need is a winning percentage of 50% to be profitable, since you make more money on your winning trades than you lose on your losing trades. However, if your average loss is higher than your average win, you need to make sure that your winning percentage is high enough to make your strategy profitable.

 

Maximum Loss:

 

Your maximum loss tells you what to expect if a trade goes wrong. And there is a difference between your stop loss and your maximum loss. Sometimes a trade can produce a larger loss than your predefined stop loss, especially if the market gaps against you and the stop loss order fails to get triggered.

 

Often you will find more information in a performance report, but these are the essential performance numbers you need to know before trading any system.

 

Reason #2: Don't Trust Anyone

 

Do not trust any performance report but your own. There are many scams in the trading education industry in which people try to sell the dream of "making millions in minutes".

 

Here are some of the shady tactics that can be used when publishing performance reports:

 

Over-optimized On Historical Data

 

Often trading systems that are for sale show performance data that has been over-optimized on historical data. As an example, the parameters for indicators, stop losses or profit targets have been curve-fitted to produce positive results over a certain period of time, sometimes even years. Or underperforming data has been excluded by applying a "filter", e.g. don't trade on the 3rd Friday of May, June and August. It is very easy to turn a losing system into a profitable system by just adding a few over-optimized "filters" on historical data".

 

Treating LIMIT Orders like Market Orders

 

Trading system vendors often treat LIMIT orders like MARKET orders, i.e. assuming that they are getting filled at the specified LIMIT price. However, LIMIT orders are being filled according to the FIFO principle, and there is absolutely no guarantee that you are getting filled AT the limit price. Often the market needs to move through the limit price before you get filled. This little detail can make the difference between a profitable system and a system that is not profitable.

 

Not Accounting For Commissions/Spreads and Slippage

 

Some of the performance reports that you might see on websites do not account for commissions and slippage. Vendors of scalping strategies and other very short term trading systems overlook the fact that you have to pay your broker when you place a trade or that there can be very wide spreads that you have to account for in trading certain markets. It is also important to note that you can experience slippage when using STOP and MARKET orders.

 

Multiple Accounts

 

It is wise to look out for audited account statements from trading systems vendors. People can often use multiple accounts to trade the strategies they are marketing, and then submit the statement of the best performing account over a short period of time for auditing. In most cases the audited account lost most of the money that was made shortly after the audit - sometimes even more.

 

Use of Hypothetical Results

 

The majority of published results are only hypothetical, i.e. the performance was never achieved in a real account. This is why regulators require disclaimers whenever hypothetical results are being published. Most people do not bother reading the disclaimers (often in small print) but just assume that the results are from a real trading account.

 

Reason #3: Determine the Profitability of a Strategy

 

Of course you only want to trade a strategy that has been proven to be profitable. However, since you can't trust any published performance statistic, you have to back-test trading strategies to get your own key performance numbers and verify that the strategy you are about to trade is in fact profitable.

 

Reason #4: Understand the Rules

 

Most strategies look straightforward on paper, but when you try to trade them in real-time, while prices are moving, you might find out that the strategy is more difficult to trade than you thought.

 

Therefore it is recommended to trade a strategy on a simulated or demo account first before putting real money at risk with a live account. Ideally, you should place a series of trades over and over on a simulator so that you can experience different market scenarios. This will help you understand your strategy better as well as enable you to grasp the psychological aspects required to effectively execute any given trading strategy.

 

Make sure that you understand the rules of a trading strategy and know how to handle exceptional situations.

 

Reason #5: Make Sure You Can Execute the Strategy

 

Many traders have a problem pushing the button and placing the trade when they see a signal. Back-testing trading strategies will help you to determine whether you can actually place a trade when a trading setup occurs.

 

Other traders second-guess their entries or exits. However you should already have a good understanding of your entry and exit rules. There is no right/perfect time to exit a trade because it is impossible to consistently pick a top or bottom of any market. Make sure you execute when you see a signal, without doubting the strategy or yourself.

 

Summary

 

There are important reasons why you must back-test trading strategies. These may be strategies purchased online, read on a website or eBook or self developed.

 

Make sure you know the performance figures, know your rules and be ready when you must take decisive action and execute a trade. Do not trust any performance report except the one that you have created yourself through testing of your trading strategies under various market conditions.

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Disclaimer – Futures, CFD, Margined Foreign Exchange trading, Warrants, Options and Spread Betting all carry a high level of risk to your capital. Only speculate with money you can afford to lose. Futures, CFD, Margined Foreign Exchange trading and Spread Betting may not be suitable for all customers, therefore ensure you fully understand the risks involved and seek independent financial advice if necessary. 


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