The Importance Of Back-Testing Part 1

BITSTAMP:BTCUSD   Bitcoin / U.S. Dollar
When it comes to trading the financial markets (any market), back-testing your strategies is an absolute must. Although past performance does not guarantee future results, back-testing your strategy cannot be skipped or rushed if you wish to be a consistently profitable trader. Back-testing can be done many different ways today. There are many good software’s & trading platforms with available back-testing tools however, I personally prefer to use a spreadsheet as they are fully customizable & require you to fully understand the operation and function of the data you compile and your strategies performance. In my personal experience, I have found that traders who use software’s as opposed to manually back-testing each trade one by one, have a much more difficult time remaining consistently profitable. One of the effective benefits of manually back-testing your strategies is that you will be training your eyes to spot your specific Conditions & Criteria’s for entry along with getting a feel for the characteristics & movements of the market you are trading.

You can manually back-test your strategies by going to your chart and scrolling as far to the left as you would like. Next you will slowly scroll one candle at a time to the right, until you see your setup. Once you see your setup, you should stop and enter the details of the trade into your back-testing tool. After you have entered the details of the trade into your spreadsheet, you should continue scrolling to see the results of the trade. Enter the results of the trade and continue scrolling right until you see your next setup.

Your trading timeframe will determine how far back in time you can go for your back-testing. For example if you are using the 60 min chart as your trading timeframe, you should be able to test several years of trades whereas if you are using the 5 min chart as your trading timeframe, you may only be able to test several months of trades. I mainly trade using the 4hr and 60 min charts therefore I personally start my back-testing process by testing 1 years worth of trades. If I am happy with the results of the 1 years worth of tested trades, then I will typically restart the process of back-testing that strategy- going as far back In time as possible. I like to have 3+ years of back-tested trades before I will begin forward testing the strategy & then ultimately trading the strategy live. If you are unsure about the amount of time that you should back-test for your strategy, you can safely make this decision using the amount of trades instead- For example, I recommend back-testing AT LEAST 100 trades. I personally will not begin forward testing a strategy with any less. If the strategy proves profitable after 100 trades, I like to back-test as many as possible. There is no such thing as to much back-testing. 

It is very important that we do not cheat during this process. Do your absolute best to scroll slowly as you proceed to avoid seeing the results of the trade before you have made the decision to enter. We must be honest in our approach to testing a strategy, in order to get the most accurate data & results possible. It is easy to see what happens next by accident & convince ourselves why we would or would not have taken that specific trade anyway. Be sure to follow your detailed conditions & criteria’s for entry as this will eliminate making discretional decisions. The purpose of pre-defined conditions and criteria’s for entry is to minimize the decision making process as much as possible. Please understand that cheating during this process is ultimately skewing the results of the strategy as well as cheating yourself!

Back-testing serves many purposes to a professional trader & takes up a large portion of their work week as we are always looking for ways to improve our existing strategies and/or develop new, more efficient ones. This stage is also crucial to your confidence in your strategy which ultimately leads to being disciplined and following your set guidelines for the strategy you are using. Your confidence and discipline to your strategy will come into play during periods of “Drawdown"

What Is Drawdown?

Drawdown is an extended period of time that a traders account experiences loss or no increase in account balance. In other words, drawdown is a losing streak OR a period of time that the account makes no gain or loss. No matter how good a strategy is, it will eventually experience a losing streak. It is extremely important that we measure the severity of these drawdowns otherwise known as "Max Drawdown". Drawdowns can vary from strategy to strategy however as an example, my strategy typically experiences 1-2 drawdowns per year and the average length of these drawdowns are around 30-40 days long. Back-testing can really help maintain emotional stability & psychological logic during these prolonged periods of drawdown. If you begin to feel doubt while these periods of time are occurring, you may go back to your back-testing results to reassure yourself that it is normal for the strategy to not achieve a profit OR even lose a certain amount of money over the course of however long your results show on average. After we have completed 3 years worth of back-testing or at least 100 trades, you will be able to go back and see periods of time (typically 1-2 months) that the account made no money at all or even lost money.

As an example- the strategy shown below carries an 11% Max Drawdown over the course of 3 years worth of trading, meaning that at some point during 3 years worth of trading, my account may experience a 11% loss from its current value at that time. This period of time is normal and as long as we do not exceed this Max Drawdown by more than 1 or 2%, we should continue trading our strategy without taking a further look to evaluate whether the strategy is outdated and needs adjusting or if we made trading related errors.

looking at the date in the top left (10/4/2018) & Date at bottom right (11/5/2018), we can see that the strategy produced little to no gain over the course of this 32 days. When first starting out as a trader, this can be extremely difficult to deal with. 32 days can feel like a very long time while it is occurring but DO NOT give up on your strategy if it has shown to be profitable throughout your back and forward testing period!! This is where most inexperienced traders begin making mistakes, breaking their rules or change up strategies thinking the one they are using doesn’t work when in fact, this is 100% normal for EVERY strategy. This is where discipline comes into play. If you do not remain disciplined and stick to your strategy/rules during these periods of time, your lack of discipline will lead to inconsistent results & ultimately failure. Lets look at what happened right after this drawdown was finished had you stayed discipline. (See Image Below)

In the following 47 days, the strategy managed to produce nearly a 90% gain! I am not saying these are the same results you will get, the point I am trying to make is to not jump from strategy to strategy or start making irrational decisions because of these periods of time. I have seen to many new traders destroy themselves because of drawdown or throw away an amazing strategy because they were unaware and uninformed about these periods of drawdown or because they chose not to back-test a strategy before using it to trade with live money. It is crucial that you extensively test anything you wish to use in the markets before using it. Take the time to feel those losses as if they were real and they were occurring in real time. Don't take anyone's word or back-testing results as your own, simply put the time in to this process yourself & you will find that your perspective of trading changes dramatically. You will start to treat this as a business and you will be one step closer to consistently profitable trading.

Note: Back-testing a strategy must be done for each market you plan to trade. For example, your strategy may be profitable on EUR/USD however that does not mean it is profitable on any other currency pair or in any market in general. Be sure to back-test the strategy for each market you wish to trade as strategy results may vary widely from market to market.

As a consistently profitable trader for the better half of a decade, the best advice I can give and the one thing I want you to take away from this post is- Always be sure to extensively back-test any trading strategy you plan to use in the markets. Without this step, you are essentially trading blind & will have an extremely hard time with your trading psychology & consistency. The software's out there today have a purpose when used correctly but I highly recommend using a more manual approach. It forces you to understand your strategy while training your eyes to spot your setups.

Some Data Points You May Want To Gather For Strategy Optimization-

I hope this was helpful for you, please leave a comment and let us know what your back-testing process looks like, and how you go about optimizing your trading strategies.