In today's guest blog post I asked Ingela Troha to talk about something that has plagued me, and millions of traders each and every year...it's back testing! Please read the full article, and put the info to good use!
Back Testing can be a dirty word for traders who are too impatient to test their trading plan. Just the thought of it feels like an inconvenience, and a delay of getting into the live markets. Also many are confused about what the process involves, or completely unaware of how valuable it is to the bottom line of their results.
The benefits of back testing are extensive; years of experience can be gained over a shorter time frame (sometimes within hours) which further develops the traders intuition as the get to know their trading plan intimately; there is also the advantage of using your trading system through various market conditions and not just the current market type; plus testing new indicators and tweaking old ones; or creating a trading plan tailored to your own personal style.
The back testing process involves taking what criteria you have within your trading plan and applying it over at least 4 years of data – pick a period including all movements; bull, bear and sideways conditions. Your trading criteria must be well defined and not open to subjectivity – if it is get rid of it and find a new indictor. Trading rules should be very clear, for example: “Enter 1 daily close above the XX Day Simple Moving Average, with a Stop Loss 25 points away…” and so on. Trading criteria must be so precise that if you were to give the information to 10 different people they would come back with the same results. If there is too much room for interpretation within your rules, you will find it hard to repeat your successes
and avoid losing trades.
Once you have applied your trading criteria over a historical period, carefully noting each trade, you will be able to reflect on each position you took and identify a number of things; you may be able to minimize the risk of each trade by moving your stop loss closer or minimize the probability of being unnecessarily stopped out by having it even further away. For example, if over the 4 year period you made a total of 100 trades where 60 were winning and 40 were losing, you could analyze all the losing trades and see if any of those could have been eliminated or minimized. You could bring in an extra rule or indicator that would have avoided the placement of those losing trades, (however, remember that a new indicator could also have subsequently not allowed you to enter some of the most profitable trades so these need to be tested for viability).
The scenarios that you can back test are endless, and the process may at the time feel quite daunting or monotonous but it is actually deepening your feel for the market by training your eye to look for market movements and patterns that repeat…setting you up as an agile trader to effectively stalk the live markets.
Back testing of course cannot replicate the emotions you will feel that fuel the live markets, but it will add to your profit margin in more ways than one. Happy back testing…
Ingela Troha is a professional trader with over 14 years experience
within the financial services industry – www.unearthedfinancial.com.au