Finding A Trading System That Works
By Trading Secrets
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, its only possible
if youre 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? Ill 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 heres 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 were a little in profit.
Obviously, a mechanical trading system goes against this grain and this
is one of the reasons its 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 youll 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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