5 Reasons to Backtest Trading Strategies

06/21/2013 6:00 am EST

Focus: TRADING

Markus Heitkoetter

Author, Educator, Trader, and CEO, Rockwell Trading Services, LLC

Traders trade to make money, so it’s important to use a strategy that has been proven to be profitable, writes Markus Heitkoetter of Rockwell Trading, but the only way to ascertain that is to backtest them yourself.

Why should you backtest trading strategies? After all, most trading strategies that you buy or read about on websites, in eBooks, or in forums already come with a detailed performance report.

Why can't you just trust these numbers and start trading the strategy?

Does it make sense to spend time and backtest trading strategies, even if you get "certified performance reports"?

The answer is YES!

Whether you develop your own trading strategies, purchase a trading strategy or read about a trading strategy in a book, on a website or in a forum: You MUST test the strategy to ensure it actually works and makes you money.

Here are five reasons why you must backtest trading strategies:

Reason #1: You Must Know Your Numbers!
There are several important performance numbers you must know before trading a strategy:

  • Total Net Profit

Obviously you want to know how much money you can expect when trading a strategy. It should be obvious but the total net profit should always be positive.

  • Average Profit Per Trade

You need to know how much profit you can expect to make on any given trade. In order to get this number, you simply divide the total net profit by the total amount of trades. Make sure that the average profit per trade is large enough to cover your commissions and possible slippage.

  • Average Number of Trades

You need to know how many trades per day, per week or per month you should expect. Here's why: If you only get two trading opportunities per week, then you need a rather high average profit per trade, e.g. $80. However, if you get 10 trading opportunities per day, then you might be willing to accept a smaller average profit per day, e.g. only $10, since you get many opportunities per day. Ultimately the average profit per trade and the average number of trades help you to determine how much money you can expect to make per week, per contract.

  • Maximum Drawdown

You need to know the maximum drawdown of your trading strategy. The drawdown is the amount of money that you lose from a high in your equity/account to a temporary low before things turned around again. Typically the drawdown is not caused by a single trade, but by a series of trades during a time, when the trading system underperforms. You need to know the drawdown that occurred in the past so that you can mentally prepare yourself for a similar loss in your account. Keep in mind that NO trading strategy produces a straight line as an equity curve. Every trading strategy has winning trades and losing trades, and you will experience winning days and weeks, but also losing days and weeks when trading a system. Make sure you are prepared to accept the risk.

  • Maximum Number of Consecutive Losses

When trading a system, you must place the next trade according to the rules as long as your trading strategy performs within the expected results. If you know that your trading system has produced eight consecutive losses in the past, then you can't stop trading if you experience four losses in a row. The higher the winning percentage, the lower the amount of consecutive losses in a row. However, there are many profitable trading strategies out there that have a winning percentage of only 40%-60%. When trading these kind of strategies, you could experience eight-12 consecutive losses in a row—maybe even more. Make sure you're prepared for a losing streak and keep trading!

NEXT PAGE: Don't Trust Anybody!

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Average Win

It's nice to know how much money you can expect to make on a winning trade. Keep in mind that you are looking at an average win. Some of your winning trades might produce higher profits, and some of your winning trades might result in only a few dollars in profits.


  • Average Loss

If you calculate your average win, you should also calculate your average loss. And as long as your average loss is smaller than your average win, all you need is a winning percentage of 50% to be profitable, since you make more money on your winning trades than you lose on your losing trades. However, if your average loss is higher than your average win, you need to make sure that your winning percentage is high enough to make your strategy profitable.

  • Maximum Loss

Your maximum loss tells you what to expect if a trade goes wrong. And there's a difference between your stop loss and your maximum loss. Sometimes a trade can produce a larger loss than your pre-defined stop loss, especially if the market gaps against you.

Often you will find more information in a performance report, but these are the essential performance numbers you need to know before trading any system. And the only way to get these number is to backtest trading strategies, because...

Reason #2: Don't Trust Anybody!
Don't trust any performance report but your own! Unfortunately there are many scam artists in our industry, trying to sell the dream of "making millions in minutes."

Here are some of the shady tactics that are being used when publishing performance reports:

  • Over-Optimized On Historical Data

Often trading systems that are for sale show performance data that has been over-optimized on historical data. As an example, the parameters for indicators, stop losses, or profit targets have been curve-fitted to produce positive results over a certain period of time, sometimes even years. Or underperforming data has been excluded by applying a "filter," e.g. don't trade on the third Friday of May, June, and August. You'll be surprised how easy a losing system can be turned into a profitable system by just adding a few over-optimized "filters" on historical data.

  • Treating Limit Orders Like Market Orders

One of the biggest problems that I've seen is that some system vendors are treating limit orders like market orders, i.e. assuming that they are getting filled at the specified limit price. However, limit orders are being filled according to the FIFO principle, and there's absolutely no guarantee that you are getting filled at the limit price. Often the market needs to move through the limit price before you get filled. I personally have seen many trading systems where this "small detail" made the difference between a profitable system and a system that's losing money.

  • Not Accounting for Commissions and Slippage

Some of the performance reports that you might see on websites don't account for commissions and slippage. Especially vendors of scalping strategies like to conveniently "forget" that you have to pay your broker when you place a trade, and that you could experience slippage when using stop and market orders.

  • Multiple Accounts

Whenever you see "audited account statements," you should assume that the vendor has been using multiple accounts to trade the strategies, and then submitted the statement of the best performing account over a short period of time for auditing. Often the audited account lost most of the money that was made shortly after the audit—sometimes even more. Do not trust audited statements!

NEXT PAGE: Make Sure the Strategy Is Profitable

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Use of Hypothetical Results
Unfortunately most published results are only "hypothetical results," i.e. the performance was never achieved in a real account. That's why regulators require the following disclaimer whenever hypothetical results are being published:

"Hypothetical performance resultshave many inherent limitations, some of which are described below. No representation is being made thatany account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differencesbetween hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance trading results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, andno hypothetical trading record can completely account for the impact of financial riskin actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses is material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results."

Long story short: Don't trust ANY performance report but your own!

And the only way to get your own performance report is to backtest trading strategies.

Reason #3: Make Sure the Strategy Is Profitable

Duh!

Of course you only want to trade a strategy that has been proven to be profitable. However, since you can't trust any published performance statistic, you have to backtest trading strategies to get your own key performance numbers and verify that the strategy you are about to trade is in fact profitable.

Reason #4: Understand the Rules
Most strategies look easy on paper, but when you try to trade them in real-time, while prices are moving, you might find out that the strategy is more difficult to trade than you thought.

Therefore, I recommend that you trade a strategy on a simulated or paper account first before committing real money. You should place at least 40 trades on a simulator so that you can experience different market scenarios.

Think about this as your "flight training." Every pilot spend many hours in a simulator, where they experience different scenarios. And they are presented with several "worst case scenarios" like lightning, instrument failure, fog, etc. This way the pilots are prepared for these situations and know what to do. You should do the same for your trading. Make sure that you understand the rules of a trading strategy and know how to handle exceptional situations.

Reason #5: Make Sure You Can Execute the Strategy
You would be surprised how many traders have a problem pushing the button and placing the trade when they see a signal. Backtesting trading strategies will help you to determine whether you can actually place the trade when a trading setup occurs.

Many traders second-guess their entries or exits. And you already know that there's no right time to exit a trade: You either exit too early or too late.

Make sure you can push the button when you see a signal, without doubting the strategy or yourself.

Summary
As you can see, there are five important reasons why you must backtest trading strategies, whether you've bought a strategy, read about it on a website or and eBook, or developed it yourself.

Make sure you know your numbers, know your rules, and be ready when you must push the button and place a trade.

And never ever trust any performance report but the one you've created yourself through thorough testing of your trading strategies.

By Markus Heitkoetter, Founder and CEO, Rockwell Trading

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