How to be a Professional Trader (Part 3) BackTesting

[ForexGuy]

I pulled into Panera Bread at around 2:15. My plan was to arrive before my 2:30 appointment so I could grab some coffee and Tom would not have to wait on me. I use Panera a lot for meetings. It’s quite, and the food is healthy. My goal was to catch the lull between lunch and dinner when there would be the least amount of distractions.

I didn’t know much about Tom. We had met at a networking function and as usual the conversation had quickly turned to trading. Tom worked in sales for a large pharmaceutical company and had been dabbling in the futures market for about a year. When I asked him how it was going, I was surprised how quick he was to admit he had been quite unsuccessful. We talked a little more about his business, how he liked his work and so on. My initial impression of Tom was that he was quite intelligent, well mannered and personable. I can honestly say I enjoyed talking with him. (Those that know me know I am not a fan on chit-chat. I actually hate networking events but a friend was hosting this one so I felt obligated to go.)

As the conversation was coming to a close Tom said, “Hey, listen. You think I could buy you a cup of coffee sometime and talk with you a little more about your trading?”

“Sure.” I said, “Anytime.” (I’m always willing to meet with someone who has an interest in trading although I rarely make the initial offer. If they approach me at least I know they have a genuine interest and are not just being cordial.) So, we both broke out our PDA phones and settled on a day.

As I approached the front door of the restaurant I could see Tom sitting at a high top table close to the entrance. (So much for showing up early.) He greeted me with a wave as I came through the door. I ordered a coffee and we both sat down at the table. I had asked Tom to bring with him a copy of his most recent trading plan. Going through a trader’s current plan is something I do very early in my evaluation process. It gives me an initial look into the trader and where they’re at in their journey toward consistent profitability.

Tom took from his pocket a folded piece of paper and opened it. On the page he had scribbled a list of rules for his trading system. As I read through it we identified and discussed many of the common problems found in most trading plans. But overall it really wasn’t a bad plan at all.

Over the course of the next few minutes we talked about his struggle to follow his plan. We talked about how he was constantly making mistakes. Taking trades off to early, entering trades too soon, then too late. He would take trades outside of his trading plan and modified his system at the drop of a hat. In short he was an emotional mess. I needed to understand where this source of emotional instability came from so I took things a step further.

“Tom, what is the expectancy of your trading system?” I asked.

“What do you mean?” he replied with a rather puzzled look on his face.

“I mean……..let me back up. Have you tested this system?”

“Well, I’ve been trading it for a couple of months.”

“But have you ever back tested the model.” I asked. “Have you collected data on the effectiveness of your system? Things like Win/Loss ratio, average number of loosing trades, maximum drawdown, average drawdown, risk adjusted return. Have you done any of that?”

“Well no,” he replied. “I’m not even sure how to go about doing something like that.”

“Tom, how can you expect to have the confidence to trade a system if you don’t even know if it is effective? Trading can be an emotional rollercoaster even if you have all the data in front of you. You’re attempting to trade from a position of weakness, and that is never a good idea.”

“Well that makes sense. How do I fix it?”

Over the next hour I talked with Tom about the process of back testing. I took out my laptop and showed him how to set up a spread sheet and enter in data like entry, stops, targets, comments, profit/loss and so on.

At the end of our discussion Tom agreed to spend the next month back testing his system and when he was done I agreed to meet with him again to go over the data. I left the meeting feeling as though Tom had a good understanding of how to take the next step in his trading. It was a great feeling. I hoped Tom would do the work. I knew if he did, it would prove to be more valuable than he could possibly imagine. But only he could do the work.

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Traders, back testing is the process of compiling data on your system by taking trades outside of normal market hours. There are several ways you can do this. If you are good at writing code, and you were specific enough in writing your rules for entering and exiting the market, you can program your system and back test it in a few minutes. If you have money, you can have someone else write the code. Or if you are like most people you can do it tick by tick in the market the way I did when I was starting out.

There are people who will tell you that back testing is worthless, even dangerous. That is an absurd. When I hear someone say something that ridiculous it is obvious to me they have never done it, and are using flawed logic to talk themselves and others out of doing the hard work necessary to be successful.

Now, while it is certainly true that past performance are not indicative of future results, here is a simple truth; since we cannot look into the future, the best measure we have for predicting future performance is the past. It’s that simple. (Oh and just so you know, it is a very good measuring stick) The day someone comes up with a better way of doing it I’ll be the first to change. Until then you would be wise to take appropriate action.

So grab your spreadsheet or a piece of paper and start thinking about the information you want to test. Date, time, entry, stop, target, profit and loss, variable money management strategies.

You may also want to test two or three different variations of the same system to see which one produces the best result. This is an especially good idea if you’re not sure if you have a profitable system or not.

*NOTE: It is important you do not “form fit” your data. This is what most scam artists do when they want to show you unrealistic results. They use a variety of perameters until they find the best fit for a specific period of time. They then apply a ridiculously dangerous money management system to show unrealistic results. When I talk about testing variations, I mean things like entering a trade at the close of a candle vs. entering after the market makes a new high. Bottom line you want your information to accurately reflect your systems performance not just look good.

By taking the time to back test your model you accomplish several things.

1. It provides you history. Plain and simple
2. When you are done you will have taken hundreds of trades over a large enough time period to see how your rules perform in both trending and consolidating markets. Along with this comes data. A lot of data, and that data is valuable.

(I’ll give you a quick example. Let’s say you where testing a trend following system, and after testing your system you determined that it produced an average monthly return of 7%. But your back testing also shows your trading system is wrong 70% of the time. Meaning 7 out of every 10 trades are losers. Don’t think it’s possible? Think again, famous commodities trader and developer of the “Turtle Program” Richard Dennis taught his students this very system. Here is the question: Would you have had the discipline to trade that system if you had not tested it to begin with? The answer is no. You would have taken loss, after loss, after loss and eventually done what you do with every system you have tried. You would cast it aside as a loser. Be honest. You know I’m right.)

3. Testing builds confidence in your system for reasons I’ve just outlined. When you hit the inevitable draw down you can look back on your testing and take comfort in the fact that if you just continue to trade your plan you will eventually achieve new equity highs.
4. You will have a standard with which to compare your actual trading record. You can literally back test every day you trade in the markets. I do this a lot with traders. I will have them trade for an entire week and then go back on Saturday and back test the week. We then look at the difference in the numbers. It’s a real eye opener for traders to see how their emotions have affected their trading over the course of a week, and what it has cost them in terms of profit.

These are just a few of the things back testing provides. Traders, if you have not done this let me be bold and say STOP TRADING IMMIDATELY. You have not earned the right to put your money at risk in the market. And I dare say you are not trading, you are simply gambling.

That’s all for this week. Until next time Good Luck, and Good Trading.

Jason Stapleton (ForexGuy)

4xtraderslive.com

[Jack Lee]

From the above, “Tom, how can you expect to have the confidence to trade a system if you don’t even know if it is effective? Trading can be an emotional rollercoaster even if you have all the data in front of you. You’re attempting to trade from a position of weakness, and that is never a good idea.” And also, "Traders, if you have not done this let me be bold and say STOP TRADING IMMIDATELY. You have not earned the right to put your money at risk in the market. And I dare say you are not trading, you are simply gambling."

So, if backtesting is so important, why is it that the first reply to this post comes a full six months later? Is the post THAT complete that readers are left speechless? No way. In my utterly bloated opinion of my own opinions, I believe that the lack of response to this IMPORTANT, even ESSENTIAL, post is a huge, if not complete, indicator of why so many have failed, do fail and will fail at trading and why the market of potential traders is so ripe for both true and false teachers and marketers of systems, programs, robots, mental discipline etc etc ad infinitum ad nauseum. Why does a picture of the world full of the word "IDIOTS" keep coming to my mind? And a picture of W.C. Fields' face all scrunched up behind a poker hand he is holding, looking with one eye to his left at some sucker??? Whatever.

Great post, ForexGuy! Thank you. I wish you the very best in your efforts to market your training. I'm sure it will be able to help a lot of folks, but I doubt a lot of folks will be helped because ultimately they will not heed your advice and, what's worse, they will complain how YOU, not themselves, are a scammer. Whatever. IDIOTS!

[fx4nerds]

lovely thoughts you put up there!
You should become a trader on zulutrade, with that attitude there will be tons of people following you :D

[fx4nerds]

Exactly that's what I am saying about my zulutrade signal providers - discipline, emotions, and less greediness unfortunately it doesn't work very well. :eek:
in order to protect myself from that I turn the zuluguard on .