The Importance of Back Testing

I'm not going to spend too much time in this book talking about how to back test, but you need to know how important it is. Whenever you buy, borrow, or make a system or have a trading idea you think may work, back test it before you risk your money. No matter what you may think the results will be, check it for yourself. If you have one of the better charting software programs, like TradeStation, you can easily test your systems with it. Even though the TradeStation programming language is called Easy Language it will take you a bit of time to learn how to write your systems, but once you get the hang of it, it's not too hard at all. I recommend taking a few systems out of trading magazines and entering them into TradeSta-tion to get the hang of how to write and program a system. Take the time to learn it, as it will definitely pay off later.

TRADESTATION CHANGES

One quick note, many people have e-mailed me saying they cannot get some of the systems I wrote about in High Probability Trading to work for them. There is a reason for this. I wrote them using TradeStation 4.0, currently they are on Version 8.3, and somewhere along the line they changed the way you enter systems. Before, you would write one long system with all the signals in it. Now it's broken up into different segments for entries and exits, making it a little different.

If you don't have a fancy program to analyze your trading ideas you can always do it by hand. You can pretty much get free charts of anything on the Internet, even intraday charts. Print out what you need and then manually go through it and write down your entry and exits and how you would have done. Your goal is to come up with a strategy that has worked in the past. Because if it didn't, odds are you will not make any money trading it in the future.

When you do back test, make sure you take into account two sometimes forgotten elements. One is commissions and fees and the other is slippage. Commissions can quickly turn a winning system into a breakeven one, because not only do you have to make a little extra on your winning trades to cover costs, you also have to cover the commissions on your losers. Slippage also can be deceiving. Slippage is the cost associated with trading that is the difference between where you think you will purchase or sell something and where you actually do get it. For example, if your system gives you a signal to buy at the market when the price reaches above 93, your system may show 93.05 as the entry point, but in real life you will probably get 93.10 or worse if the market is moving fast. Here is an example of the power that commissions and slippage have to hurt you:

You get a signal to buy at 93.00, at the time the market is 93.00 bid, offered at 93.05, so you pay 93.05. An hour later it's still trading at around 93.00 and you want to exit. However, this time the market is 92.95 bid at 93.00, so you get filled at 92.95. Your commission on the trade was $8.00 for 1,000 shares. So you end up losing $100 on the trade itself plus another $8 on the commission for a total of $108 in a stock that was virtually unchanged. Your system would have it as a wash, getting in and out at 93 even, but in reality you took a loss. So don't take these costs for granted and learn to incorporate them into your back testing if you want to stay realistic.

Another important reason for back testing is to find out the biggest drawback and longest losing streak of the system. You may think you have a great system because it is positive, but what you may not realize is that it normally has 10 losses in a row and can lose as much as $10,000 during a bad streak. This is something you would want to know before trading it. Maybe these losses are too much for you to handle and, as such, you would not be able to trade this system successfully as you would second-guess it once a losing streak occurred. Remember, you need to be comfortable with a system in order to trade it properly.

DON'T BE STUBBORN

One thing to keep in mind when using trading strategies is that they may be bad, even though you think you are trading a winning system. In reality, maybe you tested it wrong using insufficient data, or maybe you didn't test it at all. Regardless of why, don't fall in love with a strategy because you think it's great. If it is not working, reevaluate it and don't be afraid to throw it out and start again. Try retesting over a longer period with more data or over different market conditions. Maybe you only tested it in a trending market and now you are in a choppy market, and the system just will not work well under these conditions.

One good reason you want to know the biggest drawback and longest losing streak is that it will help you evaluate if and when to toss out a strategy. Maybe you think it's time to toss out the system because of four losing trades in row, but in reality this may be normal for this system, as may be an $8,000 losing streak at any given time. If this is the case and the positive streaks outweigh the losing ones and you have the risk adversity to handle these types of streaks, then you do not have to throw out the system.

You need to examine your strategies on a regular basis, so you can determine if they are still valid. If you are losing money trading a system and you test it over and over again and it seems like it should be positive, then maybe you are doing something wrong in following it. You can find this out by testing it over the period in which you traded and comparing the results. A system is only as good as the person following it. Once you start using discretion and ignoring signals, you will alter the results of the system. Maybe the system is just fine, and it's just you that needs tweaking and discipline.

WHY SHOULD YOU HAVE A STRATEGY?

This is simple: to give you an edge. The main purpose of the strategy is to make you trade with rules that you have determined will work. It will keep you from trading foolishly and from overtrading—at least from the part of overtrading that comes from putting on too many trades. Though some strategies call for a lot of trades, a strategy will at least keep your trades focused on what you think are the best trades. When you do not have a strategy each trade you make has no rhyme or reason behind it and could be totally the opposite from one similar situation to the next. With a strategy you should trade the same way, time after time after time, and hopefully you will be right more often then not, or else it's time to toss out or tweak the strategy.

Having trading strategies will help you focus on the good trades. Think of it like having on blinders that keep you from seeing all the garbage out there. These blinders will only let you see situations which you know have a good chance of working out and will keep you from acting on impulse on others you haven't prepared for. In my opinion trading is all about making the highest probability trades and ignoring all the others, and without proven strategies you cannot get that edge.

WHAT GOES INTO A STRATEGY?

Regardless of how you get your signals, a trading strategy is made up of a few things. I am going to separate money management from this part of a strategy and deal with it on its own in a later chapter. But keep in mind that the best trading strategies and a great system will not help you one bit without a proper money management strategy. So ignoring money management for now, the first thing that you will need is an entry signal, which is then followed by an exit signal. The exit is composed of two parts. One tells you when to get out with a profit and the other tells you when to get out with a loss. The exit signals are partially derived from your money management strategy, but we'll discuss that later. Other things that you may have in your system are the time frames you will trade and the holding period of your trades. You may have different systems for different markets or types of markets. You may have different systems to trade long-term and short-term. This may call for you to look at different time frames and holding periods when making your trading decisions. Regardless of these things you still need the basics: a buy, a sell, and a protective signal to have a proper strategy.

THE ENTRY

The first part of your system will be a signal to get you into the market. For example:

Short if the market dips below the trend line for two periods.

Though not as important as exiting a trade, you cannot trade if you never enter the market. The goal of the trading plan is to have a strategy that gives you trades that will have a good chance of making money. By having a system that gives you entry signals you will be making better trades than if you just winged it, which, in turn, starts you off on the right foot. If you want to succeed you need to have a valid reason for every trade you enter. Having a strategy that gives you a reason for getting in will make your trading so much easier. However, as you'll see in a second, getting into a trade is the easy part. It's the getting out where you'll determine if you make or lose money.

EXITS

Anyone can get into a trade, it's pretty easy. You just buy or sell anything at any time for any reason and you are in a trade. However, in order to make money you need to know when to get out. I could give the same trade to two traders, John and Harry, and Harry will be most likely to make money on that trade because he knows how to plan an exit. Even if he loses on it, he will probably get out with a smaller loss and restrict his damage. This, in my eyes, is long-term winning.

I'm not going to spend too much time writing about exiting now as I'll delve into it later in the book, but I'll go over the basics of it to give you an idea of what goes into the trading plan. First of all, you will want a signal that will get you out with a profit. This signal can also get you out with a loss even though it isn't meant to act as a stop. You can see how this may happen in Figure 5.3. Here, I'm using a simple moving average crossover system that only takes trades in the direction of the major trend. It buys at the close of the day when the faster moving average line crosses over the slower one. I got a buy signal at the circle E1 and sold it at circle X1 for a great trade. The next trade happened at circle E2 when the averages crossed again. I would have placed a stop just below the lows of the previous move indicated by stop line S1. Now, even though the market had not reached the stop line at the time, the trade was liquated because I got an exit signal telling me the reason I entered the trade has changed.

After the exit signal you will need a stop signal to give you a safety net. Stops are complicated, because of the many ways you can use them; again,

more on them later in the book. But overall they are just there to protect you. One thing to keep in mind is that your loss target should always be less than your profit target. If you are risking three points to make two points then you are making a poor trade. When I trade, I look at my exit before my entry and determine the risk involved and the potential earnings I can make. If the ratio is good then I start looking for an entry. If you are writing a system, look for this in your back testing. Is the proper place to put a stop versus the amount you can make reasonable? If not your system won't work. Knowing where to place stops will make you a winning trader on its own, so don't ignore them like many traders do. Even in the previous example where I do not have a set profit target, I know that in an uptrend the market has potential to move up 5 to 10 times what I was risking with my stop on a good trade. This is the start of a winning formula, you just need to be right enough times to make it tradable.

One other note, some systems will always keep you in the market. These don't use stops but use the exit signals to not only get you out of the market but to get you in the other way. The theory behind these is if I don't want to be long I should be short. These strategies are normally used by overtraders, who always have to be in something and need the action. Even if you have this type of system, I recommend using an emergency stop to protect you should the system fail to give you a signal quickly enough if you are losing big on a trade. If you go back to the chart in Figure 5.3 and remove the rule of only taking trades in the direction of the major trend, you have a system that is always in the market. Instead of getting out at point X1, you would be exiting and getting short at the same time.

TIMES FRAMES AND HOLDING TIMES

It's not enough to just have buy and sell signals, you need to determine the time frame you will be looking at and how long you will be holding trades. Here is a time where knowing yourself comes into play. Some people can hold forever and others need to get in and out all the time. As you develop your strategies, you need to take this into consideration. You need to know what time frame charts you will look at when you make your trade. Are you going to be basing your trades off of a one-minute chart or a weekly chart? I recommend looking at a range of time frames to get a true market picture and to time your trades. However, you should have a base time frame somewhere in between to actually make your trading decisions. I also recommend that when you choose your stops you look at a time frame above what you are trading to base them on.

One of the things that worked for me was looking at an even smaller time frame to actually pull the trigger. I have found that in the past I had of habit of rushing into trades. My signals would get me into the market at the highest point of a move. I was not very patient about getting in and I would get in at horrible places. One of the most helpful things I have implemented into my strategies are conditions that make me wait for pullbacks before getting into a trade, the same held for exits. I'd panic and get out at the worst levels possible. The way I do this is by overlapping two strategies. One is the basic get in signal using a daily and/or 60-minute time frame and the other is a timing signal that is usually a 1- or 5-minute time frame. I also use a weekly or daily time frame to figure out the long-term situation and give me more fodder for planning my exits. However, when it comes to actually pulling the trigger, I'm usually looking at a short time frame to time the exit if I'm not stopped out. I'll get into more detail later in the book on how to use different time frames to make trades.

STICK TO YOUR TRADING STRATEGY

This shouldn't need to be said, but once you have a strategy, use it. If you have back tested it and it works, don't deviate from it or second-guess it. If you put on a trade, make sure it is part of your strategy. Don't just randomly put on trades because you feel like it. Make sure they are in your strategy and in your game plan. Once you have your trading and game plan set, you'd be wise to follow it.

CLOSING THOUGHTS

I know I've been a little contradictory about following a system and being discretionary. I do believe you need a core system to point you in the right direction, but you can actually make the trades using discretion as long as you follow your rules, are consistent, and your trades are premeditated. This may not apply to active day traders as they have to react quickly, but even then, they should have recognizable patterns they see all the time that they act upon. As I write this book, it will be geared more toward the trader who uses discretion in his trades, as the purely systematic trader doesn't really need to follow a game plan as much because he is on autopilot. The person who uses discretion in his trading really needs the guidance of a game plan to keep him on track.

Once again, if you want to succeed, you will learn to make a game plan everyday that employs your trading strategies and you will follow it.

CHAPTER 6

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