Back Testing Trading Strategies

Back-testing trading strategies is something traders should do when building trading systems. A strategy usually starts with an impression that is coded into a formula. Back-testing that formula will demonstrate the viability of the initial idea. The goal for back-testing is to gauge the effectiveness of your idea. Here are a few tips about retrieving realistic results.

Stay away from over optimization. Optimizing data is manipulating the indicators within the strategy to gain the best results for the time period being tested. Optimizing could also be testing a specific strategy on specific equities .

Don’t kid yourself and test your long strategy on only a screaming bull market and then conclude that your method is the best ever invented. Be practical.

Test over many time frames. Try your strategy every year for the last 5 years and average the results. During that 5 year period is likely found a down market or a long period of consolidation — that will put a little realism into the results.

Back-test the strategy over a broad index of stocks — for example, the Russell 3000 contains 98% of the US equity market and is a good index to use for testing.

You don’t necessarily need a big winning percentage for success — watch the profit and loss ratio. I’ve seen some strategies have a 40% winning average and be extremely profitable. The reason — the losses are small compared to the gains.

Building and back-testing trading strategies isn’t for everyone. Often it’s easier to subscribe to a system that will provide nightly buy and sell signals. It all depends on how much time you want to devoteto trading.

For nerdy people like me it’s enjoyable to test an idea — usually something I’ve seen on a chart. Most of the time my brilliant ideas don’t produce, but how would I know if I didn’t back-test them?