The Challenge With Back Testing

As traders you only have so much available time in the day, make sure you use it wisely.
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We have a quick question here from a new subscriber asking how much time they should spend on back testing their technical trading strategy.

So, thanks for the great question, this is something that I haven’t discussed in a while so it’s a good way to quickly run over a few important points when it comes to back testing.

For those that don’t know, back testing, as it is used in the more traditional sense among traders is when a trader tests a specific technical strategy by seeing how it performs with historical price data.

The idea around back testing is that if the trading system can be tweaked and enhanced, we might be able to find a strategy or system that can generate consistent profit. If a system is profitable with historical price data then it should also be profitable in the future.

One of the snags with these type of systems though, is that it can usually only be done for purely mechanical technical strategies as you can’t program fundamental news into it, it will have to rely on a pure rules-based technical system which executes and closes trades in a mechanical way.

The biggest challenge with doing back testing, is that it might tell you whether your technical approach has been effective on that specific instrument with those specific parameters in those specific conditions, but it can’t account for the most important part of your analysis, which is the subjective part of the fundamentals where, as a trader, you try to think how the market should react after a particular news event.

The whole concept of behavioral finance means it will be impossible to account for a trading system just by looking at historical data, as the participants are never the same, the conditions are never the same and the underlying idiosyncratic factors are never the same.

One area where certain hedge funds has found success in back testing is at a whole other level by running economic model back tests which tries to track the type of effects changes in growth and inflation has on various asset classes during certain market conditions.

Thus, when growth and inflation moves the same or against each other, depending on where we are in the economic cycle, it can have provide a high degree of accuracy for suggesting which asset classes should perform in particular ways depending on those ever-changing factors.

So, what does this mean for you as a retail trader? It means, don’t get bogged down with things that won’t really affect your profitability. Focus the bulk of your energy on getting to learn how prices move, why prices move, how markets think about things, getting to grips with some of the more nuances factors that cause investors and traders to act the way they do and think the way they do.

This will be a far better use of your time in the long-run in my honest opinion. So, don’t go telling people that I said don’t do back testing, if you want to test a technical systems with back tests go ahead, but don’t let that be your focus, and especially don’t try to trade the markets by only using that without considering the fundamentals, that path usually ends in frustration and disappointment.

So, hope that helps, any other questions just let us know.

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