Why Backtesting Trading Strategies is Essential
In our latest training webinar with Traders Support Club, we had the mandatory nature of backtesting hammered home to us. Thoroughly backtesting trading strategies is, they believe, the only way to be a successful technical trader. Perhaps this should come as no surprise to either us or our listeners. Ali Crooks’ first appearance in Podcast Episode 31 was focused on backtesting, and when Ceri Bryans came on Episode 42 she berated us for not being thorough enough!
Last week’s training journal entry was all about the importance of having strict trading rules, and this week’s entry builds on that. Last week I said that strict trading rules allow you to take the Ego out of trading. This week I will suggest that strict trading rules allow you to put Confidence in it’s place. Without proper trading rules, accurate backtesting becomes all but impossible. And without backtesting your trading strategies, how are you ever going to know that they will work?
Don’t Waste Your Time
Here at Two Blokes Trading, we are big fans of using a Trading Journal. (We recommend Edgewonk by the way). Without a trading journal there is no way of ensuring that you continuously improve through self analysis. This is what some traders call forward testing, and I highly recommend it. However, until you have forward tested a trading strategy for at least, say, six months, how can you possibly know that it is a winning strategy long term? Forward testing is great for tweaking your performance to ensure you wring every possible pip from your trading strategy. But if you want to make sure you don’t waste six months of your life on a system that simply doesn’t work, then you are going to have to accept that backtesting trading strategies is mandatory!
Proving it to Yourself
Aside from the obvious point above that backtesting is the only way to prove a trading system actually works, you have to consider the effect that backtesting has on your trading psychology. Since starting Two Blokes Trading we have interviewed over fifty traders and industry insiders, and it is startling just how many of them place trading psychology as the number one skill to master. Not to mention it being the biggest factor in your profitability! Backtesting your trading strategies is one of the key ways to ensure that your trading psychology is on point.
Even though Traders Support Club have given us proven trading strategies as part of their course, they are still making us independently backtest them. This may seem counterintuitive - if you have paid good money for a trading strategy that they know works, why spend hours or days proving what they already know? But Ali and his team know that unless a trader knows that their system works over the long term, they are almost certainly going to give up in the first rough patch. It doesn’t matter who has told you it is going to work, you have to prove it to yourself.
One of the biggest reasons for backtesting a strategy, even one that you have been told works, is that you need to understand what a drawdown period looks like for this particular strategy. For instance, if you have a losing month in your second month - is that expected? If your backtesting data shows you that in any given year you can expect two or three month-long losing periods, but overall for the year you will be up, then you won’t panic. But if don’t know this for a fact, then a month long losing period will see most traders quit on their system, even if it actually makes money in the long term
Why You Need Strict Rules
I have, until recently, been trading a sentiment and fibonacci retracement system for forex. I have traded this because I like combining the two, and I think fibs are awesome. But, it proved an absolute pain to backtest the trading strategy. This is because sentiment is almost impossible to test in historic data. How much time would it take to go back and look at all the headlines, economic data and Twitter storms that were happening at any given moment in the last several years!? So I had to only backtest the fibonacci element of the system...and hope that my reading of the sentiment could improve the numbers overall!
This is a less than satisfactory way of doing things, but I can’t see a way around it. For the pure technical trader, you don’t have any such problems. Create a system with strict rules, backtest that trading strategy, and away you go. If you don’t build strict rules into your technical trading system, then you are only making things harder for yourself.
Different Styles of Backtesting Trading Strategies
You may have listened in despair to some of the episodes we have done on backtesting - it all sounds like a lot of work! The research and planning stage of any project just doesn’t appeal to some people. If you are more interested in the action than the planning, you may find that you continually skip the backtesting. So it may interest you to listen to our interview with Kym Watson on Episode 54 where he outlines his belief in simple backtesting.
Ithe idea of a vast Excel spreadsheet and recording countless parameters is enough to put you off backtesting trading strategies altogether, then Kym has a solution. He calls it ‘back of a fag packet’ backtesting. (That’s a cigarette packet if you don’t know your British idioms…) What he means is that grabbing a pen and paper and just recording winners, losers and the amount of pips is sufficient to build confidence in a trading system for some people. If the other option for you is to not do it at all, then I’d suggest taking Kym’s advice!
However You Backtest, Just Makes Sure You Do It
There is software out there that enables you to automatically backtest a trading strategy over vast amounts of data. If you are good at technology or considering running your strategy as a trading robot then this may be a good option. Equally, manual backtesting has its own advantages - actually spending time with the screens will build knowledge, experience and ‘feel’.
You may choose to backtest trading strategies in great detail over long periods of time with complex Excel spreadsheets. Or you may choose to do only fifty trades’ worth of data and just record winners and losers.
However you choose to backtest, I cannot overstate the importance of actually doing it! Otherwise I can almost guarantee you that you will commit the cardinal sin of new traders.
The Cardinal Sin of New Traders
Tom and I have jumped between a few different systems, some that have been making money and some that were losing it, but none that we have stayed with for more than a few months. Despite our access to some of the best traders on earth we have fallen into the classic new-trader trap of system hopping.
Why is this? And why is it only now that we are committing to sticking with something for the long term? Quite simply, it is because we did not adequately backtest our systems. Tom backtested his technical trading strategies, but only over a limited data span and not in enough detail to be personally satisfied that he knew they would make him money in the long term. So, in periods of drawdown, he was tempted by the forbidden fruits of another system.
For me it was the difficulty of adding in the ‘sentiment’ element of my trading styles into my backtesting that left me cold when it came to my belief in the efficacy of the system.
If you don’t backtest your trading strategies I can almost guarantee you that when you hit that inevitable drawdown period you will commit the same cardinal sin of new traders and hop to a different system. Then you will have to start the whole fruitless process all over again!
So, grab that pen and paper, or fire up that Excel spreadsheet, and get backtesting.
If you are interested in learning more about backtesting then we thoroughly recommend learning with Traders Support Club.