I often speak with traders that want to back test their strategy and trading ideas before going live. They spend days and weeks pouring over data attempting to simulate every market condition to see how their “program” works. The goal is to find the ideal situation where a trader’s ideas compare with past market conditions to produce profitable (hypothetical) results. A considerable amount of time, effort, energy, and capital are tied into back testing-but does it work?
Before delving into back testing we must first identify how traders approach the markets. There isn’t a trader alive who isn’t searching for a new idea, indicator, or edge. The goal of any good trader is to maximize profits by assuming the least amount of risk and minimizing losses. To accomplish this, traders are constantly refining their ideas, studying charts, researching data, and searching for market inefficiencies. A logical step in this process would seem to be to back test strategies. Before risking capital, a trader wants to make sure that the strategy has worked in the past.
However, the fact is that professional traders don’t really back test. I personally know hundreds of traders from prop traders, to hedge funds, to local market makers and not a single one has spent time back testing.
Why Don’t Professionals Back Test?
It Seems Like a Good First Step.
Professional traders don’t back test their strategies because it doesn’t really tell them how their ideas perform or operate under live conditions and present market activity. What seems like a logical first step to trading is really just testing how the market traded in the past. Simply looking at a chart could tell a trader the same facts. But why doesn’t back testing tell a trader anything?
One reason why back testing doesn’t work is because market conditions constantly change. Factors that have affected the market in the past may have no relevance in present day activity. Furthermore, new conditions such as volume, interest rate, and volatility may create new inputs for a market’s behavior. For example, the S&P’s volume has skyrocketed since the 90’s, the yield curve has shifted causing the 30 year bond to lose volume, and the volatility in gold has dramatically increased over the last year. Why test a strategy on market conditions that occurred years ago? If the Chicago Bears prepared for a game against the Pittsburg Steelers by studying tapes of the 1975 team, one would question the coach’s sanity. The same can be said by testing an S&P strategy on market conditions that are 3 years old. Markets are sensitive, and the nuances are constantly changing. Why would a trader analyze conditions from the past that have no bearing on the present?
Moreover, interpreting the data is only part of the battle. Studying data doesn’t prepare a trader for the emotional and mental discipline of trading the markets. This is often the hardest aspect for traders to overcome. Back testing data does not take the mental challenges into account. Getting out of a losing trade, managing a winning trade, the self-doubt of a strategy; these are inputs that cannot be duplicated by back testing. For a trader to think that they can take emotional and mental factors out of trading is like telling someone to not be hungry. These issues are prominent, and how a trader reacts to these conditions is the difference between long term success and failure – not how their system worked ten years ago.
How Do I Approach a New Market or Trading Idea?
If back testing doesn’t work, how does a trader get comfortable with an indicator, a methodology, or a market? The answer to this isn’t as glamorous or cerebral as one would think. My advice to traders is to use a couple indicators that they are comfortable with, have confidence in them, and stay calm. Trading is far more mental and emotional than technical. The technical aspect of trading is the easy part, staying mentally strong is the challenging part. The indicators are simply ideas that a trader interprets to assist in trade entry and exit. Paper trading present market conditions can help a trader get comfortable with the market or idea, but only live trading can create the true atmosphere taking all market aspects into account.
Whether you’re trading the mini S&P, gold or cattle, indicators are all the same. Once money is involved, moving from simply studying the markets to controlling emotions is vital. No amount of back testing can prepare a trader for the challenges of live market events. The indicators that a trader employs are only as good as the trader that uses them. However, indicators are not the magic formula; they are only one part of a bigger picture. Trusting the tools that you have and maintaining your discipline is the most important part of trading. While the professionals realize that market analysis is important, being mentally present and emotionally strong is the key to making good trades.
Many books and market educators discuss their methodology or system simply because it sells. It’s easier to back test a methodology than to work on the psychological aspects of trading. Few people want to hear that there isn’t a shiny object or a magic formula that will lead to profits. Most traders feel that if they only change a few indicators and run a couple more tests, then they will find the right combination to success. This leads a trader to buy the newest program or back test the latest indicator. However, if a trader only spent that time concentrating on the indicators they already have and psychologically preparing to trade, they could save a lot of time and be better prepared to trade the markets. Unfortunately, this is just too simple for many to comprehend. But often times, the simple way is the better way.