How to test a trading strategy

You may be building your own trading strategy from scratch … or trying someone else’s on for size.

Either way, how do you know if it’s going to make you money, and is the right system for you? You need to test it … but you need to know how to test a trading strategy properly.

The bottom line of just how profitable it is, is only a fraction of the story. But if you run through these 6 checklist points, you should have your bases covered …

How to test a trading strategy properly

Any system needs to work in a number of ways …

1. 1. 1. It needs to make money

      2. It must fit in with your lifestyle

      3. It must fit within your means

      4. It’s ups and downs (all systems have them), mustn’t be too volatile for your taste.

      5. It must have been properly tested over a decent period of time

      6. The results achieved in the trial period must be repeatable

Let’s look at each of those in turn …

1. Does it make money?

Of course, this comes first. A system is not worth a thing if it doesn’t actually WORK at making a profit. But, there’s making money … and there’s REALLY making money. By which I mean something that actually puts the pounds and pence into your account, rather than just looking good on a spreadsheet.

The past performance …

If you’re looking at a tried-and-tested trading strategy, you’ll want to be asking about whether results are live tested, demo tested or back tested – there’s a huge difference here:

Live testing is real trading in a live environment – it doesn’t need to be with a lot of money, but it’s using real live market prices.

Demo testing is just like live trading, but on a demo account – it looks and feels the same, but bear in mind that demo accounts often use a different data feed, so prices may be subtly different to the live account (this can make all the difference).

Back testing … well, this is a dark and murky area, so I’d like to throw some light on it here …

Back testing is the process of applying your trading strategy to historical data in order to check how it would have performed in that period.

Sounds fair enough, and like a very sensible thing to do – but the simple fact is that because of the knowledge we have about the past, it’s far easier to create a profitable system that will work on historical data than one that’ll work in the future.

There are a number of reasons for this …

I can run through the charts, and find the optimum trading times, I could hone my profits targets, fiddle my stop losses – and miraculously score again and again. In fact, I can even introduce some new trading rules to explain away the days when the market misbehaved. (Like “Never trade on a Tuesday when there’s a letter ‘r’ in the month”!)

I’m not suggesting that there’s no place for back testing – but it is no substitute for testing a trading strategy in the real market.

Even if I apply the strictest rules to my back testing, it’s hard to ignore the things I know about the timeframe – the general bearish or bullish nature of the markets over that period … or the volatility of those months.

Nothing beats strict forward testing of trading results … first in a demo account, then in a live environment.

If I see someone flogging a trading strategy with a handful of months worth of backtested results – I run a mile. And I’d suggest that you do too.

Of course, even with meticulous back-testing, and rigorous live testing – we cannot have any guarantee of whether a strategy will be profitable in the future. If you want guaranteed returns, then trading isn’t the place for you.

But if you’re prepared to take some measured risks, and in return have the opportunity to significantly out-perform the market – then you’re in the right place.

But profitability doesn’t stop with there. The other 5 factors in this list can make all the difference between success and failure … so your system has to pass these too …

2. Does it fit your lifestyle?

Can you make the time commitment? If a trading system requires that you spend 8am to midday glued to your screen … and you have a day job … then (unless you have a VERY understanding boss), it’s not for you.

Be realistic about the time you can spare. Some of the best trading systems trade less often rather than more often, so you needn’t compromise on profits if you’re short of time.

3. Does it fit within your means?

Is this a trading system that requires you to trade the S&P with a 600 point stop loss, and minimum stakes of £1? That means your risk will be £600 per trade … if you’re risking 2% of your pot, that’d need a trading fund of £30,000.

A bit rich for many people.

Or it might require you to open lots of trades at the same time, eating up all the margin in your account.

What size fund do you have? And is it possible to trade this method safely within your means?

4. Are it’s ups and downs too volatile?

Profit curves, like financial markets, and celestial bodies, don’t move in straight lines.

With any trading method, profits will go up … they’ll go down … they’ll go up again … and so on. If you’re doing it right, the general direction will be an upward one.

The downs that happen along the way are called drawdown.

A large drawdown is not a pleasant thing, but it’s worth remembering that often the trading strategies that advertise the biggest profits have drawdown levels that would give most traders a nosebleed.

Drawdowns are an important and inevitable part of any trading strategy. No system can win all the time. And when you hit a few losses (we all do), it can be an uncomfortable experience. Drawdowns can have a huge psychological as well as financial impact on a trader, and many traders only learn what works and doesn’t work for them through painful trial and error.

You can’t expect a perfectly smooth profit curve, but look for something that won’t give you sleepless nights, and has a good success rate … and keep your risk nice and small, so you won’t get shaken when those inevitable losses come along.

5. How long has it been tested for?

When you come across a trading method that’s working, the temptation is to jump in with real money as soon as possible, so you can cash in on those profits.

So, how long do you need to test for before you risk real money?

This really depends on the kind of trading it is …

If you’re trading 15-minute charts, you can probably test a huge number of signals over the course of a month.

If you’re trading daily charts, you’ll probably need around 6 months of data to get the same degree of proof.

But also be mindful of trading conditions for the period you’re testing … was the overall market in a strong trend? Was it especially volatile at that time? A change in these market conditions could then stop your very successful strategy from working.

Of course, it’s just not possible to test a system across all market conditions – because markets are always changing, and no two ‘bull markets’ are identical. But it’s good to be aware of this, so you can adapt.

6. Are the trial results repeatable?

I touched on this issue last week … the trading guru who shows you his amazing results, and promises to show you how to do the same …

… when you fall short, he’ll then tell you how he ‘wouldn’t have taken that trade because of that obvious hammer formation on the 11.30 candle’ … or he ‘would have come out early because of the Bank of Japan statement that was due out’ …

That’s all very well if you’ve the time to take your study of the markets to those levels.

But if you want a simple, repeatable system, that doesn’t require you to read the financial press or take a degree in candlestick analysis … this is where you need simple rules that can be repeated again and again, like following a recipe.

And the good news is that (while they are few and far between) systems like this do exist – and these are the kind of trading methods that I’m always on the lookout for.