Discover Why Back Testing Automatically Increases Your Confidence

After creating your system, there is one final element to any trading system – you must make sure that you test your trading system using historical market data. By doing this, you can increase your confidence that your system produces the results that you desire. Additionally, if your system consistently produces poor results when you test it then this may be an indication that while your system may work on paper, it may not actually work with real data and you may want to look at the system in more detail.

There are additional benefits of back-testing:

You can test data safe in the knowledge that there will be no actual money lost when you work out your trading winnings or losses.

You can test your system in a variety of different market conditions – bull, bear and sideways in a relatively short space of time.

If your trading system is completely mechanical you can programme a computer to work out the system parameters automatically saving you a lot of work and time

While it may seem that this is the ideal way of testing a trading system, there are drawbacks to back-testing.

You may forget or disregard essential expenses such as spread of stocks and broker fees – these can alone make a system that indicates a winning performance to a system that actually loses money.

The back-testing will automatically assume that you are in and out of the trade at the optimal level. For example in very fast moving markets or in markets that are low in volume, you may actually get filled at a level that is not quite what you indicated to your broker. As such, “slippage” is another cost that must be taken into account when back-testing your system.

While back-testing increases your confidence in your system, it does not guarantee that your system will be a winner – remember the market will do what it wants to when it wants to!

It does not take into account the emotion relating to trading – this must be factored into any system. In other words, can you trade this system without emotion?

One of the reasons why trading systems that are actually produce good results in the testing phase but are awful in real time trading is that the drawbacks are not taken into account or that they have been underestimated.

The last thing that you need to take into account is that some systems are very difficult to back-test. For example, how easy would it be to calculate fundamental statistics that were relevant a few years ago if it is crucial to your system or how would you react to a piece of news that was released 5 years ago? The easiest systems to back-test are the systems that rely entirely on mechanical buy and sell signals relating to price action – data in these instances are much easier to obtain and analyse by computers.

There are many programmes that enable back-testing. For example, Metastock has an inbuilt system analyser. However, to get an even more realistic performance, programmes such as TradeSim can be used.

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