Testing your Trading System

I just got permission from Norman Hallett, from Thedisciplinedtrader.com, to show you an excerpt from his newebook, "How To Design and Construct an Effective Trading Plan".  This ebook is not for sale to the public and is only offered to the students of his buzz-worthy "The Disciplined Trader Intensive Program" where he trains traders to be mentally and emotionally disciplined.

I've personally known Norman for years and his programs are the best in the industry, and his knowledge is used by top traders including many within INO.com. He's giving away 4 special reports which I highly recommend grabbing while they are still free, HERE.

This excerpt is about Testing Your Trading Plan... and it's worth the read... because without a tight trading plan... you're nowhere as a trader ...


Developing a successful trading system based upon your specific goals and a set of trading rules form the heart of your trading plan. These two documents wrap around the “fuzzy” part of your personal goals, aspirations, strengths and weaknesses and your preferred style of trading. But how do you know when you have a system that will meet your needs?

Today’s trading environment makes becoming a successful trader much easier that in the past. The electronic age has not only greatly reduced transaction costs but has also mad available a wealth of information available from any place on the globe. One of the most positively impacted industries was that of the world of finance. One of the most profound effects was that of the evolution of electronic trading. Not only did it offer 24 hour trading capabilities but it changed the trading paradigm. As a result of computer to computer bid-ask matching, many of the most knowledgeable people in the industry-the market makers and floor traders-suddenly found themselves no longer needed. Indeed, the new technology forced them out of the pits and into the field of education. In the logical pursuit of putting food on the table, many former “insiders” needed to leverage their knowledge. As a result, new online trading institutions have sprung up on the net Now, the independent trader community has access to formerly closely held information on not only the mechanics of trading like a pro but also the more subtle psychological considerations of being a trader.

Part time traders and aspiring full time traders can now have access to knowledge not formerly available to the public. From online courses to full time mentoring, the internet has opened up a whole new opportunity for a person to carve out a new and potentially very rewarding career without needing to take time out from an ongoing profession or to convert free time into productive time (many “house wives and stay at home dads are exploring the possibilities of trading). Indeed, businesses of all types are entertaining the idea of using a portion of company free cash for trading purposes. In view of the low levels of returns offered by most financial institutions, if a trader can develop a fairly low risk way of generating an ROI above 10%, many capable business owners are looking at trading as part of a new way of generating additional revenues to help optimize assets.  But is it possible to develop a trading system that is relatively low risk?
The answer is yes.

Given that you have put in the time to learn about investing and the types of investment vehicles that you feel are best for you to trade in, the trading plan is the first step in the process. As mentioned in Chapters 5 and 6, step by step procedures need to be developed and formalized into a document or checklist. Once you have established your procedures, the next step is to try the out.  Before the advent of paper trading via an actual trading platform, aspiring traders were more or less forced to sink or swim with their money on the table.  However, today, aspiring traders can build a professional trading plan and test it out before getting rolled by the pros.

When undergoing the testing of your trading system, you not only get to test your system but you also become experienced in using the trading platform and all its nuances. Moreover, you become comfortable with the trading process and how best to set up entry, exit and stops. In addition, most brokerages have seemingly come to the realization that many investors want to become educated and take a more active part in managing their investments. As a result, brokerages now make a much more serious effort to educate their clients by offering regular seminars and online webinars on trading education.

As mentioned before, the paper trading account is one of the most important tools a trader can have. Not only does it allow testing to help come up with a system that produces at least a 65% win-loss ratio over at least 100 trades, but it also provides a “safe harbor” when a system needs to be taken out of action for adjustment if production is not what it should be. Most traders will set up a trading rule whereby if the win-loss drops below its expected win-loss ratio over a certain time number of trades, the trader becomes obligated to stop trading and go back to paper trading to troubleshoot the system. Indeed, paper trading is the test bed.

Most statisticians will say that a significant sample size is about 100 test trades but this is just a rough estimate. A better way would be to test in different market conditions. For example, how does your system function during an up market with moderate volatility, in a down market with low volatility, etc, etc? However, this could take some time so as a general rule, it is probably a good idea to do at least 100 trades to develop the win-loss ratio but take into consideration that the macro economic environment of the market can have a distinct impact on how your system performs.

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One thought on “Testing your Trading System

  1. While paper trading has its place I think trading real money in small amounts provides a much more valuable experience. This is bit more difficult with futures because even 1 e-mini contract represents enough leverage to cost "real" money to a trader but with stocks it is very reasonable to trade 10 or 20 share lots. Pick an amount where getting stopped out will cost you about the amount that you would pay for a good meal, say $10-$20. This is enough for you to notice but nothing that should be significant for even a small trader.

    Transaction costs will eat up a large share of your profits in this scenario but that's not the point. It gives you a feel for things that paper trading often does not. For instance : what's a 'real' fill entering or exiting a position; how does your software work under real market conditions; what's it like to have your data feed or exchange go down while you're in one or more positions; and perhaps most importantly what's it like to have money on the line, even in small amounts, while the market is actually trading tick by tick. All these things are theoretically possible with paper trading but I have found they are just too easy to blow off mentally and emotionally with nothing on the line.

    The gain or loss of real money, even if it's only 10 or 20 dollars makes an actual difference, often times because it reinforces somthing that paper trading does not namely that decisions and mistakes have consequences and create/cost real money. Didn't put in a stop, didn't wake up in time for the open today, wasn't paying attention or was away from the screen during a critical time in the market, entered your order incorrectly, entered with wrong position size, forgot to close a position, forgot to enter a position, couldn't get filled at your target and didn't know how to move it in real-time, overnight gap against you, overnight gap in your favor; etc...The list is almost endless. Do you REALLY care about these things when you're paper trading?? I know some of you think you do but for me it was just never quite the same.

    Once you start making money (ignoring commissions) with ultra small position sizes then you can move up the food chain and start to trade greater size. At least by this time you won't be struggling with the mechanics of trading in real-time (although the need for disciple never goes away) when you have more significant amounts of money at risk. Then you can start to confront the mental and emotional challenges to success that face a trader on a day-to-day basis.

    Good trading,

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