Welcome to this video on backtesting trading strategies. The irony is that using trading backtesting software may be the absolute worst way to design trading strategies.
Learning how to backtest a trading strategy using excel, MT4 or another software program seems like a good idea at first. But it’s not. This video and article will walk you through the logic of exactly why, and what to do instead.
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BACKTESTING TRADING STRATEGIES
Welcome to this video on backtesting trading strategies I share with you my experience with backtesting which I have done for well I did do for many many years. I don’t do it anymore and I’m going to share with you why. I have very sophisticated software very high powered computer system and I was trained in how to do this I’d find a few strategies that were viable historically.
Then what you do typically is you understand that’s curve fitting. So then you take the successful strategies and you apply them to data that is separate from the data used historically that’s called out of sample forward testing. So most of them when I took them and use them on out of sample data they failed the night. Ninety five percent of them. So then that last 5 percent which is very hard to find.
TRADING BACKTESTING SOFTWARE
I would then start treating real live markets in current time and none of them were successful over the long period of time someone worked for a little while and then ultimately fail. So why is that. I started to wonder because I spend a lot of time on that and I was very disappointed. So I started thinking about it. I realized you know there are some real problems with the whole idea of backtesting. Here’s the first one.
You’ve seen this legal statement everywhere. Go ahead and fill in it just in your mind just fill in the the end of the sentence. Past performance is no guarantee of what you know the end of this. Most people do. We see it everywhere in websites and on documents that people send to us brokerage firm software whatever. Past performance is no guarantee of future results. This is why trading backtesting software isn’t reliable for futures profits.
HOW TO BACKTEST TRADING STRATEGIES IN MT4
So we’ve seen it everywhere. You knew that. That’s a problem. If that’s a legal statement that all these companies put on their documentation that means that that’s a very significant issue and it is in fact that many studies have been done on this Couple of a moment or in 2014 a Wall Street Journal study found that only about 14 percent of Five-Star funds retained their reading 10 years later.
Past performance was not indicative of future results. In 2013 a Vanguard study reported that the one stars and now we’re looking at the other end The Wall Street Journal analyze the Five-Star at Vanguard study the one stars and they had the actual greatest excess returns what they call when compare it against a benchmark. So wow. What the heck’s going on. Yes I hate the opposite of what you would expect especially when most people make decisions on funds to buy based on their past performance. If this is true, then learning how to backtest trading strategies in mt4 may be futile.
HOW TO BACKTEST A TRADING STRATEGY USING EXCEL
Well to me what that indicates is there’s probably a reversion to the mean. We all know that very very few people ever outperform just the benchmark the S&P 500. And so therefore if it does outperform for a while it reverts back to the mean if it underperforms for awhile revert back to the mean. So that’s one huge problem.
Another one is that markets change over time. Back when I started trading which is decades and decades and decades ago I’d have to call my broker on a rotary phone of all things my kids don’t even know who the rotary phone is anymore. They see it in a museum. But yeah we didn’t I mean we had a black and white TV. So learning how to backtest a trading strategy using excel may not be applicable to today’s markets when using long-term historical data.
BACKTESTING TRADING STRATEGIES FREE
We certainly didn’t have computers. And so there’s no direct access. You know there were no low commissions commissions or high cost me 50 bucks to get in 50 bucks to get out decimalization wasn’t around. There was no mobile devices didn’t even have a computer. Bottom line was trading was slow slow and expensive and therefore chart patterns trended more today. People use all this technology to get in and out of the market real fast. That creates choppier chart patterns.
The patterns today are different than they were back then. Now that’s on the retail side. Now on the professional side you’ve got Elgood trading high frequency trading. It got dark pools. So the speed of what’s going on here in the retail around the professional sites even faster. And so again you get different type of chart patterns than you did in the past so. Add to that, the fact that many traders want to use backtesting trading strategies that are free and well, you get what you pay for!
Okay that’s great. Now that all begs the question of all day what do we do. So the first thing to acknowledge is are no certainties in the market. Part of that reason we do free backtesting is we’re looking for some certainty as to what’s going to work in the future. And so acknowledge that there’s always risk in the market. You know back in the days of Jesse Livermore they used to call it speculation. I still prefer the term speculation to trading because it reminds me that there’s always risk in the market.
Here’s how I trade here the principles I use two things. Number one market logic and mathematical logic. So what do I mean by these. Well let’s take emerging market logic first. So I’m referring to the market profile model where the market is seen as an auction place and in an auction place you’re beating on memorabilia and so forth art whatever it might be and that that item that’s going to sell for whatever someone is willing to pay for it.
BEST WAY TO BACKTEST TRADING STRATEGIES
And that’s how the markets work too. We’ve got this global auction place essentially. But the logic of the markets not always logical. Sometimes people pay more than many people would think that a piece of art is worth because they have sentimental connection with that. And the same thing happens in the financial markets. So and we see that with bubbles. We’ve seen it in the real estate bubble recently. Before that we saw in the technology bubble before we even start with tulips. If you go back farther and of tulips of all beings and of course this is what Alan Greenspan referred to is as irrational exuberance.
The market logic is the logic of well logic in quotes of people and psychological studies have shown that people generally. Even though we don’t admit it to ourselves we generally make decisions based on emotion and justify them with logic. And so the market logic is not individual psychology but mass psychology that plays a major role in how markets move. Thus, there may be no best way to backtest trading strategies.
FREE BACKTESTING SOFTWARE
The second part of the larger equation that is the mathematical and got to include this too. Because over half of the shares in the New York Stock Exchange aren’t traded by human beings Well I should say they aren’t. The decisions the trading decisions are made by computer models and some of these don’t really affect you in your trading and you certainly can’t compete against them.
You and I cannot compete against these. You’re not going to get free backtesting software or a forex robot on the Internet for $19 that it is going to compete with Goldman Sachs or Merrill or Bank of America. So here’s what I do. I combine these two types of logic. And the bottom line is that mathematically measuring what the market participants are doing now. So again remember it’s market participants globally and I’m taking a treat now.
I need to know what’s going on in the market right at the second entering the trade. Now what happened you know six months ago 12 months ago 40 years ago I trade in the present bar by bar and manage my risk and then I use indicators to objectively and mathematically measure the money flow in and out of the market. Now that’s what we’re looking for the money.
GET MY FREE MARKET ENTRY TIMING INDICATOR
BTW, if you’re interested in the indicator that I use personally for very precise entries and exits. I’m happy to share that with you. Just send me an email at Barry@TopDogTrading.com, and I’ll show you how to get access to that indicator.
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