In this post I want to share a useful technique I use that will speed up your progress to becoming a profitable trader and save you money in the mean time. If you’re not already familiar then it’s what’s called backtesting.
I talk about most points in the video but for more information keep reading below the video.
Backtesting is a way of seeing just how a particular rule-based strategy would have performed had you traded it in the past. I’m a big fan of backtesting and would never put money at stake before I had backtested the strategy and was happy with the performance. I’ve read many trading books over the years but find the subject of backtesting is seldom talked about.
Once you have your set of rules for entering, stop loss and profit taking you are then able to test signal by signal on a chart of previous data. I personally have a fairly standard format of spreadsheet I have developed to record every trade. Once you have a large sample of trades (numbers vary on types of strategy but the more trades in sample the better) you can then pull some very useful statistics from it.
I like to know at minimum the following once I have the backtest data:
- Trade Expectancy
- Average winning trade size
- Average losing trade size
- Win to Loss ratio
- Frequency of trades – Average amount of trade signals per year
- Maximum amount of losing trades in a row
- Maximum drawdown
I also like to see how the strategy being tested performs in different main market types; during bullish markets, sideways markets and bearish markets. I may find that it only works well in quiet bull markets and loses money during other times. I would then select to trade that strategy only when I know it performs best.
So already you can see how backtesting a strategy can help save time and money rather than cluelessly trading a set of rules you have no idea are going to make or lose you money. Of course, past performance of a strategy has no guarantee that it will continue to work in the future but if the rules are fundamentally sound and has performed well in backtesting over many years and trades, then it’s likely to do well in the future too.
I like to manually backtest my strategies. This means trawling through price charts carefully looking for every signal. Yes this can get tedious and take a long time but well worth it in my opinion. There are ways to speed up the process by automating it. Many charting packages offer the ability to backtest much faster.
I would really love to hear about your own experiences with backtesting and what you think about the process, especially if you use a charting package or programme to do it. Just leave a comment down below or email me firstname.lastname@example.org.