The Secret Art of Backtesting

If you have not back tested your trading system, you might as well trade with your eyes close.

In fact, whatever technical analysis criterion you use to trade with, be it moving averages, candle sticks, volatility breakouts, fibonacci retracements or any other trading system you have devised you're going to need to back test your trading system thoroughly and objectively in order to remove any possible doubt about it's capability.

To remove any self-doubt you need to thoroughly back test or simulate your trading system in such away that it matches the conditions under which it will be traded. Once you have established that you have a reliable and robust trading system only then will you be confident in trading your system.

When trading what is the question in most traders’ mind?

To answer this question I shall quote the introduction from Chapter 8 Back Testing of Mark Jurik’s book Computerized Trading:

Will my trading strategy be profitable? After having gone through the arduous process of crafting a trading strategy, these are the questions you must ask yourself. The ability to answer these questions are the great promises that back testing holds out for all traders. A successful back testing procedure will greatly reduce the probability that you will begin trading with either an unprofitable strategy or one that does not meet your expectations. By adopting a sound and rigorous back testing approach, you will:

Pinpoint which approaches to the market that are likely to be successful and which ones are not.

Generate good estimates of future performance for each trading strategy you test.

Create a record of your trading strategy's historical trading performance.

Produce data necessary for other components of your trading approach such as your asset allocation strategy.

Important Trading System Criteria

Profitability is not the only criteria by which a trading system should be evaluated. Drawdown and stress should equally be considered as well... for example, before you open a trading account:

Are you satisfied that your system is reliably profitable?

Will drawdowns wipe out your account?

Is your system trading in a way you can tolerate?

Can you tolerate long periods of no trading or too much trading?

Can you tolerate a large string of losses?

The only way to answer these questions is to subject your trading system to extensive back testing.

Lack of Confidence

Lack of confidence usually forces traders to question their own trading systems. They give into the temptation to modify their trading plan with devastating consequences. This temptation spawns on by a string of losing trades or an opportunity to replace their trading system with a whiz-bang indicator that is usually talked about in traders chat forums.

Anything that sounds to good to be true will attract the attention of a trader who is not satisfied with their own trading system simply because they have not properly tested their system in the first place. In addition, they have not built up the necessary confidence needed to successfully trade the system developed.

In the end these negative subconscious thoughts will only hinder and destroy your ability to trade successfully. To improve your confidence in your trading system you need to thoroughly and objectively back test it - simple as that! Only then will you be confident enough to commit time and money to it!

The Traders Dilemma

How can you test how a trading system will perform over a period of time when trading an arbitrary group of securities?

--- To truly evaluate the past performance of a trading system you need a trading simulator, which mimics the day-to-day trading activities of a typical trader. Until now this kind of software has been out of the reach of most traders. In fact, there has been some great headway in back testing software. Personally, I use TradeSim with MetaStock.

TradeSim is the first realistic true trading simulator/analyzer for Metastock that can quickly back-test and evaluate a trading system across a portfolio of securities. With its powerful data processing capabilities, TradeSim can evaluate the historic performance of a given trading system within a matter of minutes and do it with a realistic representation of a real-life trading scenario. Whether a single security or a multiple security portfolio, TradeSim answers the simple question:

"What would of happened if this system had of been traded in the past using an arbitrary portfolio of securities?"

Sounds simple - but is extremely complex if not impossible to do with Metastock as it stands alone. However, with TradeSim it is just a simple matter of running a Metastock exploration on a portfolio of securities using your own set of indicators. When the exploration has finished you just simply run TradeSim and analyse the resulting trade data.

Your system may look good with an expert overlayed on a single chart.

"But what about it’s real world trading performance?"

Typically, your system will consist of entry and exit triggers, prices as well as an initial stop loss. These five parameters basically define a framework for a trading system. The trouble with trying to back test a trading system is that the system tester built into Metastock is only extremely limited. As a result, this can give a very distorted view of your potential trading system performance. TradeSim addresses all of these issues whilst exploring new ground in technical analysis and uncovering new issues that have not been addressed by current software technologies.

Remember, no matter what back tester you go for, anything that sounds too good to be true will attract the attention of a trader who is not satisfied with their own trading system. This due to the fact that they have not properly tested their system in the first place and have not built up the necessary confidence needed to successfully trade it.

In the end, these negative subconscious thoughts will only hinder and destroy your ability to trade successfully. To improve your confidence in your trading system you need to thoroughly and objectively back test it - simple as that! Only then will you be confident enough to commit time and money to it! By testing your system, you have just put yourself into the top 1% of traders.

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The Secret Art of Backtesting

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