TOP THREE FOREX BACK-TESTING TIPS
There is one distinguishing characteristic between those traders who continually struggle to find consistent profits and those traders who consistently pull profits from the market. The traders who are still looking for consistency, who are still looking for profits, are traders who usually do not back-test trading systems. These traders fall in love with a system before establishing the veracity of the system. These traders often move from trading system to trading system, hoping that the new system will yield better results than the previous system. The consistently profitable traders
take a different approach. These traders know that they have a profitable system because they back-test their system extensively. These traders have seen their system work over years of market data and know precisely the type of drawdown they are likely to come up against in the future.
The choice is yours; you may decide to join the group of struggling traders who jump from system to system, never really finding comfort with any trading system, or you may decide to join the successful traders, the profitable group who spend time back-testing their systems. If you decide to join the latter group, I have three back-testing tips for you. These tips were developed by working with traders just like you, around the world. The key is to approach your back-testing as you would any skill you are working toward. If you were looking to learn the bass guitar, you would probably want to take lessons and spend time playing your guitar to hone your skills. However, it is important that you play the bass guitar in your own style. Back-testing is much the same. You must approach it seriously, but you must also keep this in mind: You will consistently find profits only if you stay true to your trading style.
1. Consider Your Style
Use a back-testing method that fits your trading style. If you are an automated trader, then use automated back-testing; if you are a discretionary trader, use manual back-testing. The most important thing in back-testing is to duplicate your trading style. Back-test in a way that will be meaningful and bring you closer to expertise with your system.
2. Take Time to Test
There is a real temptation, particularly when engaging in manual backtesting with software, to do it much too quickly. Back-testing is a learning process. Just as you would not expect to complete a 16-week course in a day, you will need to break up your back-testing sessions, particularly if you are doing manual back-testing. Try to keep your sessions short—under two hours—so that you approach each session with a fresh mind and you are unlikely to get sloppy. Back-testing for six or more hours will usually lead to poor results simply because you were not as sharp for your last
trades as you were for your first trades.
3. Mistakes Are Part of Back-Testing
Making mistakes is also part of the learning process. We have a natural tendency to avoid mistakes. So when a trading mistake pops up several times, it is tempting to modify the trading system so that it accounts for this mistake. However, this is the road that leads to too many variables in a trading system. Avoid too many variables. Try to keep your system rules simple. It may be tempting to add a new rule to avoid some losing trades, but this may blunt the effectiveness of your system. If you are interested in naked trading, trading without indicators, then you are likely to avoid the “too many rules” mistake. This is another reason why naked trading allows traders to realize their full potential.
Naked trading also involves using the history of the market. If you ask any psychologist how to best learn about someone, you will hear that it is best to follow that person around. Psychologists do not have the time to follow people around, so questionnaires are used to determine what somebody is like—their personality, their habits, and their history. Likewise, the naked trader may use the history of the market to determine what is likely to happen in the future. Everyone has done something and said, “Why do I do that?” People like to believe in free choice, but most humans are creatures of habit. Likewise, the market is a huge amalgamation of habitual traders. The market is nothing more than a community of creatures of habit. People make up the market. The naked trader uses this to his advantage, by closely following historical turning points in the market. We will get into this issue in detail later in the book, but for now it is important to remember that the naked trader equates the market to a herd. Herds willoften follow one anot her for safety. Members of a herd will also fall on one another as they run off a cliff. The naked trader uses specific tools to tune into and take advantage of the herd behavior that we call the market.