Finding A Trading System That Works For You

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Back Testing A Trading System

Back testing a trading system involves applying the rules and conditions of a trading system to historical data. To do this, it’s only possible if you’re trading a system that is entirely mechanical and does not require any discretion to trade. How can you know whether or not your trading system is completely mechanical? I’ll ask you this question. Could you take down your trading plan, your set of rules and guidelines that you follow, and can you hand that over to someone and they could trade the same trading system and receive the same results if they follow the system? If the answer is yes, you have a mechanical system. If the answer is no, I would recommend that you look at implementing – my personal opinion is that you should look at implementing a completely mechanical trading system, and here’s why.

Back testing does not give you 100 percent accuracy as to the profitability of the trading system once you start trading it. The reason for this is price movements are never going to be exactly the same. That said, price is driven by supply and demand. Supply and demand is a direct result of decisions made by humans. For this reason, you can assume that price movements in history, although not exactly the same as the past, may mimic and have similar attributes over time.

With this in mind, back testing a trading system can give you confidence in your system. Perhaps one of the hardest parts in trading any system is to have the confidence to stick with your trading system. In fact, a mechanical trading system almost forces you to make decisions that are in direct conflict with what your gut feeling might tell you what to do. Remember, our gut feeling tells us we should hold on to losing stocks to wait until they get to break even, and our gut feeling would tell us to sell shares as soon as we’re a little in profit.

Obviously, a mechanical trading system goes against this grain and this is one of the reasons it’s psychologically difficult to trade. However, by back testing your trading system, you can quantify the probability of your system with reasonable certainty. As long as you make sure you back test your trading system over different market conditions, it can be reasonable to draw parallels as to the performance of your system historically to trading it in real time.

There are two ways you can back test a trading system. You can do it manually, which can be time intensive and a very laborious process, or you can do it with the aid of some software packages. I recommend when you first start out, you do it by hand. The reason is you’ll get a much better feel for your trading system if you understand the way it works and its intricacies. Once you understand this, you may look at finding a software package that does it for you.

Most successful businesses keep statistics on everything from their trading system to their average dollar sale to the amount of people that come in the door. The reason a successful business will do this is because they understand you must first keep score before you can begin to improve on that score. Trading is exactly the same.

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