Backtesting your Trading Strategy
Congratulations, if you completed the previous exercises you now have a complete systematic, rules-based, trading strategy!
Before you can start trading your system, you must backtest your strategy to ensure that it has a positive expectancy and makes more money than it loses. The ability to backtest is one of the major benefits of a systematic, rules-based, trading strategy versus a discretionary trading system. There is no way to accurately backtest a discretionary trading system in which stocks are randomly selected with no consistent approach. Knowing that your strategy has a positive expectancy, or an edge, will give you the confidence to place every trade that your system generates. The ability to trust your system is key to your short-term and long-term trading success.
When you are initially developing your trading strategy, a good way to determine if the strategy has potential is to quickly benchmark it against stocks that have a history of trending well. For example, you could look at the historical stock charts of Apple or Amazon and test your strategy. Would your trading rules have identified the stock as a potential trade setup, and would your rules have allowed you to enter the trade and stay with the trade for a good portion of the trend?
Once you are confident that your strategy has potential, you need to do a full backtest before you start trading live. To start, you are going to want to backtest a minimum of 100 trades. Assuming you are trading using a daily time frame, a typical trend following system could generate 1 to 2 trade entry signals per week or approximately 100 trades per year. Your system needs to generate sufficient trading opportunities to meet your profit objectives. There are software packages available that will allow you to backtest strategies, but the suggested way to backtest is to use the same process you will use when you are trading live. Websites such as Stockcharts.com have advanced scanning features that allow you to run historical scans. You want to ensure that you test your strategy to see how it performs in upwardly trending markets, sideways markets, and downward trending markets. A good way to do this is to review the stock index from where you are identifying potential trade set-ups and look for a historical one-year period where the chart of the index exhibits these three market characteristics.
You will then start generating historical scans from the start of this period to identify potential trade set-ups. Remember that you will only consider new trades when the index is above your identified moving average (Trading Rule #1). Scan one week’s worth of historical data at a time for the index you are following to identify potential trade set-ups (Trading Rule #2). You will then review the historical stock charts of each potential trade set-up one at a time. You will need to ensure that you are able to choose the historical start and end date of the chart you are reviewing and set the chart up so that the right edge of the chart matches the date it showed up in your scan. You will then advance the chart forward one day at a time to determine if your buy trigger is hit (Trading Rule #3). You can use your Voodoo Trading Journal to record your backtesting trade info just as you will when live trading. You will want to keep a spreadsheet to record all you backtesting statistics.
If the trigger is hit, you will then calculate your stop loss exit (Trading Rule #4) and calculate the number of shares you can buy and total cost based on your money management rules (Trading Rule #5). You will then continue to advance the stock chart one day at a time to determine if your stop loss price is hit. If it is hit, you will record this in your spreadsheet as a losing trade. If the trade continues to trend, you will calculate your trailing stop exit (Trading Rule #6) and advance the chart ahead one day at a time until the trailing profit stop exit is hit. You will then record this in your spreadsheet as a winning trade. The benefit with this method of backtesting is that you are able to record your backtesting results, but it also conditions you to systematically implement your system making it easier once you start live trading.
You will continue this process until you have recorded a minimum of 100 theoretical trades. The more trades you can backtest, the better. This process will take a fair amount of time, but it is crucial to your trading success. From these backtest trades, you will be able to extract valuable data that will help your live trading. You will be able to determine the percentage and dollar increase (or decrease) on your starting capital. One of most valuable pieces of data will be the winning (or losing) percentage of your trades. If your trading system is comparable to most trend following trading strategies, this number will be somewhere between 30%-50%. The most important piece of data is your risk(R)–multiple. To determine your R-multiple, you need to calculate how much money you made or lost from each trade vs. the amount of money you risked. If on your theoretical $100,000 account you risked 0.5% or $500, and on a losing trade you were stopped out for a $500 loss, your R on the trade would be -1R. If you have a winning trade that made $2,000, your R on that trade would be 4R. If you take the average of all your 100 trades and the R-multiple value is greater than zero, you have a profitable trading strategy. A good trend following strategy will have an R-multiple of somewhere between 1R and 3R. Knowing the R-multiple of your trading strategy is powerful information. If your R-multiple average is 2R, every trade you make, whether it is winning or losing trade, has the expectancy of making $1,000. If your system generates 100 trades a year (winner and losers), you can assume you will generate $10,000 of profit. If your system generates 200 trades a year (winners and losers), you would generate $20,000 of profit. This information should give you the confidence to take every trade your trading strategy generates and implement your trading strategy like a business.
In the next lesson we will start Using the Voodoo Trading Journal to execute your trading strategy.
Download our step-by-step guide - "How to Build a Systematic, Rules-Based, Trading Strategy" and start trading your way to financial freedom!