You know that successful traders share the backtesting habit. You know that backtesting separates the wealthy traders from those who lose money. You also know several ways of incorporating backtesting into your trading regimen. And you know of the pitfalls – what to look out for – when you are backtesting, so that you can get the most out of the process. But, what exactly, will you get out of backtesting your trading system?
The answer is – plenty. By backtesting your system, you will become more relaxed in your approach to trading. You will know what to expect in the future, because you have seen your trading system in so many different market environments, and you will remain confident in your ability to make money from the markets. Let’s look at these “side effects” of backtesting.
Traders who use backtesting to validate their trading strategies know that success is coming. Traders who do not backtest their trading strategy fall into the “circle of doom.”
What is the “circle of doom?” This is simply the place that most traders are stuck in, where the trader trades a system for a while, then after a series of losses, gives up on the trading strategy, finds a new, ‘better’ trading strategy, trades the new strategy for a while, experiences several losses in a row, then gives up on the trading strategy, searches for a new trading strategy, etc. The trader is doomed because the trader is not committed to a successful trading strategy. Even if the trader does have a successful trading strategy, the trader will not make money because it only takes a series of losses for the trader to give up on the trading strategy.
The trader with backtesting experience approaches trading from a much more relaxed perspective, knowing that, while there are no guarantees that a particular trade will make money, in the long run the trader will make money. This trader has no need to stress and frantically search for a new trading system after experiencing a series of losses. Which way would you rather trade? As a relaxed trader or as a trader in the “circle of doom?”
Anticipate the Future
How can traders anticipate the future? By extensively backtesting their trading systems. Does this mean that the past market behavior will be repeated? Of course not. But a trader who decides to backtest a trading strategy over many years, in various market conditions (uptrending, downtrending, very volatile and very quiet) will collect very important statistics on the trading strategy.
The most important statistics are as follows:
+ The percentage of winning trades – call this W%.
+ The percentage of losing trades – call this L%.
+ The average gain of a winning trade – call this Ave W.
+ The average loss of a losing trade – call this Ave L.
Here’s why these statistics are important – with just these four statistics you can find out how good your trading system is, and thus decide if it is worth it to trade the system with real money. With these four statistics you can calculate expectancy of your trading system. The formula is as follows: Expectancy = (W% x Ave W) – (L% x Ave L)
The expectancy number tells you how much money you would expect to win over many trades. Perhaps the easiest way to illustrate expectancy is by an example.
Let’s say that trader Jeff has a trading system that he backtests using manual backtesting, over 900 trades, and he gets the following statistics.
W% – 30%
L% – 70%
Ave W – $450
Ave L – $120
Calculating expectancy, Jeff sees that (0.3 x 450) – (0.7 x 120) = $135 – $84 = $51. So, armed with this information, trader Jeff knows that if he takes 100 trades with his system, and the average winning trade is $450, and the average losing trade is $120, even though he is likely to have only 30 winning trades, he will still probably make $5,100. How does Jeff know this? He knows this because he knows that (30 x $450) – (70 x $120) = $13,500 – $8,400 = $5,100
This doesn’t mean trader Jeff will make $5,100. This only means that we would expect him to make $5,100 over 100 trades. Of course Jeff’s real results could be a little better or a little worse, but they are probably going to be very near $5,100 after 100 trades.
This is what backtesting is all about, learning about your trading system, learning how to trade it, learning how it holds up in various markets, and learning how much money are you expecting to make from this system. Calculating expectancy will go a long way toward helping your confidence as a trader, a very important attribute to have.
Once you have seen your trading system perform over hundreds of trades, over years, in markets with vastly different characteristics, you begin to trust your trading system. Because if you have seen the trading system make money over hundreds of trades, in volatile markets and in quiet markets, and in everything in between, you know that the probabilities are in your favor.
That is really what trading is all about – probabilities. Once you gain confidence, you begin to see trading for what it really is – a game of probabilities. Each trade is not that important, but the overall sequence of trades is very important. Whether the current trade is a winner or not does not matter too much. But the fact that your trading system has been backtested, and has a positive expectancy, is very important.
This means that you will be able to trade your trading system daily in much the same way a casino operates. The casino has no interest in whether a particular bet makes money or loses money for the casino. The casino only cares that, overall, in the long run, the casino will make money. You as a trader will learn confidence, will learn to trade detached from the outcome of the current trade. You can be more confident in your trading when you know, you really know that over time you will make money.
You have become the casino. Now go out and enjoy it!
Walter Peters, PhD is a professional forex trader and money manager for a private forex fund. In addition, Walter is the co-founder of Fxjake.com, a resource for forex traders. Walter loves to hear from other traders, he can be reached by email at firstname.lastname@example.org.
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