Back testing is a necessity for anyone day trading a strategy and is serious about this business. If you have experience in trading then you will have learnt a lot of stuff along the way but by planning and having confidence in your strategy can make a huge difference to your bottom line. It can be the difference between a healthy account and one that is often on margin calls!Throughout this article I’ll touch on the concept of back testing and related important points. Back testing is simply replicating past transactions triggered by signals in your strategy on historical data. It helps to test how effective and robust the strategy is. By taking a starting point (let’s say 2 years of data) and working through it recording each trade, the stops losses, the profits, the drawdowns, you can create quite a clear picture of how effective the trading method is, and also (more importantly) build up trust so when losing trades come your way you have confidence the strategy will pull it back if the rules are adhered to.
1. Take a starting point and move forward. Get historical data down to 1 minute or tick data. Move through that data making sure no triggers were false. Do not lie to yourself or you will lie to your bank account. If a trade is a loser in the past, make it a loser on paper and be confident the picture you end up with is a true reflection of past performance.
2. Add up the drawdown. One of the most important aspects of back testing is to understand how far the losing trades drawdown on your account balance. This will inform you how much capital is needed to trade the strategy effectively allowing for margin and lean times knowing that your day trading will build it back up if rules are not broken.
3. Don’t allow the market to play with emotions. Back testing your day trading strategy over many years of data will allow you to see numerous ways the market interacts with it. You will know how often prices come close to your stop loss, take profits and will maybe shed some light on how it can be improved. But the most important this is the trust relationship it will build. Even after a sustained period of losing trades you will know 100% that if you keep day trading the same strategy following the rules like a robot then the market has no hold over you or your emotions. Trust will let you make important decisions when the market is volatile.
4. Improvements and tweaks. Maybe you had a rough method or idea. You back test it and see that it works but not as well as you had thought. However along the way you notice something, some reoccurring pattern. Maybe a type of candle or breakout happens at certain times, these are things you will only pick up on by back testing. You can make a note of them and then build them into your strategy, possibly improving performance and of course your bank balance.
So, these are just some of the many reasons why you HAVE to back test your day trading strategies. It’s a no brainer really. Anyone who doesn’t do it, well, why not save yourself a load of time and heartache and just transfer your wealth direct to your broker..