The Idiots Guide To Back Testing For Confidence
After you`ve set your initial stop loss, chosen your method for
calculating your trailing stop loss, and implemented all your
money management rules, there is one last thing you should do;
you should begin back testing your system.
With out back testing you will be headed in the right direction,
but you won`t know what to expect from your system. Back testing
will also give you the confidence to keep going when you begin
to experience the doubt that every trader faces at some time.
Back testing your system is by applying the rules and conditions
of the system to the stock`s historical market data. However,
this is only possible if you`re trading a system that is
entirely mechanical and does not require any human input to
place the trades. How do you know whether or not your system is
completely mechanical for back testing? Can you take down your
trading plan, the set of rules and guidelines that you follow,
and hand that over to someone else, who could then trade the
same system and receive the same results as you would if they
followed the system carefully?
If you can do this, you have a mechanical system that is ready
for back testing. If you can`t, you should look at implementing
a completely mechanical system. Perhaps one of the hardest parts
in trading any system is to have the confidence to stick with
your system. In fact, a mechanical system almost forces you to
make decisions that are in direct conflict with what your gut
feeling might tell you to do.
Remember, our gut feeling tells us we should hold on to losing
stocks until they get to the break even point, and our gut
feeling would tell us to sell shares as soon as we`re a little
bit in profit. Obviously, a mechanical system goes against these
human tendencies, and that is one of the reasons why it`s
psychologically difficult to trade. However, back testing a
mechanical system, will tell if you it your plan will work or
not.
While back testing will not tell you with 100% accuracy what the
profitability of your system will be once you start trading it,
it will give you a very good sense of what you can expect. All
prices are driven by the same two factors, supply and demand, in
the present and in the past. So, even though price movements are
never going to be exactly the same, in your back testing you
will see the patterns, and similar movements that show up over
time. With back testing you can discover the how profitable you
system is likely to be, and how often you are likely to have a
loss rather than a profit.
Back testing your system over different market conditions, it
can be reasonable to draw parallels as to the performance of
your system historically to its performance trading it in real
time. Knowing this, because of back testing, will make it much
easier to stick with your system, and the profits you can
realistically skyrocket.