Back Testing is one of THE most important parts or steps of becoming a trader. The reason behind that is a very simple one that many new and experienced traders overlook. Throughout our blogs and our course we talk about building a strong foundation to continue to grow as a trader and that really starts with back testing.
First of what is back testing? Back testing is the general method for seeing how well a strategy or model would have done . Back testing assesses the viability of a trading strategy by discovering how it would play out using historical data. If back testing works, traders and analysts may have the confidence to employ it going forward.
Simply back testing is how traders prove to there self that they have a profitable system and set of rules. This alone will boost confidence and help you make those hard decisions when they come up. By back testing your system and your rules you will know when where and how to enter and exit trades.
A few items that all traders need to back test and have rules on are as follows.
How are you going to enter? This is a very simple answer with a potentially very complicated answer. Are you going to use and ATM, what type or order are you going to enter with, are you buy the bid or the ask, are you selling the bid or the ask. These questions all need and answer and be back tested to prove to your self that the answer you came up with is one correct and two is profitable.
Same thing goes for exiting a trade. Are you going to exit with an ATM, if so what type or order are you going to exit on. It could be an if touched order or limit order or maybe you wont use a set order and maybe exit by hand. Again before you risk any of your hard earned money these are the simple questions you need to have answered and back tested.
What's going to signal you into a trade? Is it going to be a candle stick pattern or maybe a certain time frame, the list could go on and on. What traders need to do is find a signal type and back test it until they are proved right or wrong.
When it comes to being right or wrong, traders will have to be able to admit when there system is wrong. This shouldn't be an issue if you are documenting the process and being ridge with your results. You'll simply need to go back and see whats not working, make a slight adjustment and go back to testing.
This process will continue until you have a proven system. Once you have a proven system it is always wise to test that system in SIM/Replay for an extended period of time.
Not only will traders want to test this system for a period of time but they will also want to test this system in all market conditions. Those conditions include, bullish,bearish,ranging, fast and slow. If at any time they run into issues during a certain market condition, they will have to go back and see what adjustments are needed for that type of movement and make the correct adjustment.
It is extremely important to keep proper documentation on what is working and what is not working. This way you will prevent yourself from trying the same adjustments over and over.
Once you have a proven system it is then suggested that you document the system and make sure it is easily available for you to view throughout the day. This will help when you might have to make a decision, you will know exactly what to do in that situation.
Many new and experienced traders often over look the back testing phase due to the fact it is very time consuming. Would you risk your hard earned money on a business adventure you know nothing about? I hope the answer to that question is no. Trading is the same exact way, there is no reason to risk your money on something that you do no have the proof that it is profitable.
Do you routinely back test your system? If so comment down below!