Correct Backtesting of a Profitable Trading System

One of the hardest things for beginning traders is the backtesting process. Backtesting can be hard and annoying because it requires attention to detail and is very time consuming. But the backtesting process can also be very rewarding. In this article I will focus on manual backtesting but the main principles outlined here can also be easily applied to automated backtesting.

Main benefits of backtesting a trading system

1. The main benefit of doing backtesting is obvious, finding forex systems that you can trade. Backtesting allows you to see if a trading system is profitable over a longer period of time, not just over the few weeks you’ve spent trading a certain system on a demo account. This process will allow you to see how your system performs over a long period of time and through different market conditions. Some systems excel in flat trading periods while others outperform during trends. Every financial instrument goes through these two main phases. It is important that your test is long enough to include both trends and ranges in the mix.

2. Gaining confidence in your trading system. If you’ve done the difficult backtesting work and you’ve learned what you can expect from your trading strategy you’ll be lot less likely to give up on it when the going gets tough. Every system goes through ups and downs. The testing process allows you to quantify this. Is the current slump just a normal variation in the larger scheme of things? Or is it a sign that the strategy is starting to lose its edge?

3. Knowing when to quit – Backtesting will also help you to find out when to stop trading a particular trading strategy. Has your system stopped working or are you just encountering a normal variance of trading results? Backtesting avoids this guessing game and helps to make these types of decisions a lot clearer. Put a number on this. If the max drawdown reached during the backtesting was 30 percent and you’re currently only down 16 percent there is probably no reason to worry. But if the drawdown starts pushing that 30 percent figure, consider revising or entirely dropping the trading strategy.

Hindsight and correct backtesting

They say that hindsight is 20/20. Nowhere is that more true than in the business of trading. Looking back it’s easy to spot all the trades that you could’ve taken that would’ve made you millions. It’s also easy to disregard the losses. Oh, I wouldn’t take that loss because of this reason or that reason. In this particular trade, I would’ve placed my stop just a little wider but of course I won’t extend that rule to every future situation that is similar in nature, only to this one, because this is a special one-time event.

Any trading strategy, including news trading, should be thoroughly backtested. Due to the volatile nature of news events even profitable backtests may fail to deliver gains when traded with real money. Liquidity and trading restrictions around fundamental releases can significantly impact your bottom line. However, this shouldn’t be an excuse not to conduct a proper backtest. While a backtest is no guarantee for profits, having no backtest is an almost certain guarantee for a loss. For example, say that you’re doing a backtest and you decide to ‘’loosen’’ your stop because the market ‘’looked like’’ it might turn around soon. You now need to universalize this rule, extent it into the future and apply it to all similar situations. You need to define what do you mean by ‘’price looked like it might turn around soon’’. Was it the Stochastic Oscillator screaming caution oversold market! Did the Euro just complete a triple top pattern? Whatever the reason, define it in a clear and objective manner so that you can easily apply it to all future trades.

After you’ve defined your ‘’event trigger’’, you’ll need to extend that rule going forward. If you loosened your stoploss because the Stochastic Oscillator moved below 20, you need to loosen your stop every time the Stoch crosses this threshold in the future. Trading is never about special events or hitting the jackpot. Profitable traders play the odds, just like a casino does. They don’t count on making millions on one trade but instead focus on eking out a small edge over the course of million trades. If you want to backtest news trading strategies, makes sure to do it right.

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