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How to Properly Test Your New Strategy

How to Properly Test Your New Strategy

2013-05-23 03:00:00
Tyler Yell, CMT, Currency Strategist
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Article Summary: The benefits of fully testing a system are many. Top of the list is that a fully tested system that clearly displays all metrics of a system can give you the confidence to push your edge when a favorable market arrives. Also, a fully tested system allows you to act with machine-like accuracy as to when it may be best to cut your losses and start trading another system.

Building a trading strategy that you’re comfortable executing is no easy feat. However, once you’ve found the right mixture of indictors and risk management that you’re comfortable with it comes time to test. Only with the test of your strategy will you know if the newfound strategy is worth repeating.

Why Test Your Strategy?

Successful trading systems are not as common as many would have you believe. If you walked into a local bookshop or searched successful trading systems, you would at first believe that there as many long term successful systems as there are website hits or books on the shelf. As you can imagine, just because you’ve read something impressive at first sight doesn’t mean the system will play out in the future as you hope.

Learn Forex: It May Look Good, But Does The Strategy Work For You?

How to Properly Test Your New Strategy

It’s been said, wisely, that no one cares as much about the outcome of your trading as you do. Because you alone (unless you manage money) have to live with the results, you should focus on properly testing any strategy that you’re looking to employ. This will ensure that you only trade strategies that have passed your due diligence as opposed to something that sounded good when you first heard it.

How to Test?

First, you want to have a set of rules to follow. Second, a flow chart can help you lay out a process from pre to post-trade. Lastly, you want to follow the rules with machine like precision to test the system appropriately.

When trading, there are two methods or avenues that you can choose to test a strategy. You can choose either a demo environment with no real money at risk or a live environment with a sample amount of trading capital. Testing a strategy with real capital allows you to get a feel for how your emotions mend with the new strategy.

Of course, you can exercise both options by first testing your strategy on a demo and then moving a relatively small live account. Once on a live account with your new strategy, it may be best to trade one contract at a time and only increase your trade size should you receive a new signal or you see marked success with your strategy. However, by limiting your trade size in a testing period, you’re allowing yourself to focus on the validity of the system vs. your day p/l which isn’t what your testing time is about.

Learn Forex: Be Precise About Your Test Criteria

How to Properly Test Your New Strategy

What To Look For After The Test Sample Is Completed?

Because trading is about managing probabilities, it’s helpful to see if the consensus of your sample meets your criteria of a valid system. Here is a list of 7 fields that you should consider when testing a system’s effectiveness:

Total Net Profit: Profitability irrespective of the risk taken. This is a positive or negative number that shows the net p/l of the system over a fixed number of trades. Many traders stop here which can be a big mistake because a large profit can be achieved in the short term by taking excessive risk. However, excessive risk on a long enough time line can lead to eventual ruin which we must avoid.

Number of Trades: Total number of trades will show you the validity of a system’s results. All things being equal, a test with a higher number of trades should be given more weight because it shows how it performed over many signals.

Average Duration of Trade: Duration of trade will tell you how long a trade was in the market. This is important because a trade in the market is tying up required margin. If you’re a short term trader and the average duration of the system’s trades are longer than your preference then it may be best to adjust the system and start testing again or find a new system.

Max Drawdown: Max Drawdown will display the maximum peak-to-valley drawdown during the test period. In other words, a trade taken at the absolute worst time (buying at a top or selling at a bottom) delivered how big of a hit to equity. Max drawdown will also give you a good view as to how much equity you need to trade with to allow this system to trade appropriately.

Maximum Consecutive Losses: Consecutive losses help you see how many consecutively losing trades were endured through the test. The benefit of knowing the consecutive losses number ahead of time is to help you keep your sight on the overall prize as opposed to being discouraged to the point of quitting if an arbitrary number of stops are hit. Knowing this can be especially helpful to trend followers whose major profits happen on a handful of trades.

Profit Loss Ratio (P:L): P:L helps you see average profit to average loss ratio. Naturally, the higher the number the better because a large positive number shows you profits overcoming losses. Trend followers often have higher p:l ratios while short term range traders often have higher win %.

Percent Winners: Percentage of winning trades. This helps you see the edge of your system when the market environment aligns. This number is best when combined with a positive P:L ratio.

You can create a simple excel spreadsheet to house all of this data. The sheet should include the strategy name and market conditions needed to operate along with these fields. When the conditions align, you can go to your strategy sheet to see which is best for you.

Closing Thoughts

When developing a system, less is more. Trading with the simplest rules possible while still having an edge leads to a higher probability that you will stick with the system in a favorable environment. A simple system will also likely have a higher propensity to display results similar to the tested period given the parameters of the test align with the current environment.

Happy Trading!

---Written by Tyler Yell, Trading Instructor

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