One Intense Backtest…and a Method That Passed
• “Statistical Validation” and “Benchmarking”
• One Critical Factor That’s Often Overlooked
• A Proven Trading Indicator at Work
Traders must simulate their trading strategy under a literal gauntlet of varying market conditions in order to effectively measure its performance, and should do so before ever risking a dollar of real money.
Before risking real money in a trading account, it is a good idea to have a rule-based trading plan in place, and one that works in both up and down markets.
A “rule-based” plan is one where all trading decisions, from trade selection, entry, and position management are all dictated by established rules. The biggest advantage of a static, rule-based plan is that it can be tested for validity in all different trading environments (i.e. bull, bear, and/or sideways market conditions) before ever risking real money in the market. We call that process “statistical validation,” or “benchmarking.”
Once a method and its performance have been tested first hand, it becomes possible to gauge the probability that the particular method will produce desirable results in the future.
The best methods will work in all market environments, but typically, some environments are better for most strategies than others. What works in a market experiencing rising volatility may not work as well in a market experiencing falling volatility, and vice versa.
It is always easier to gauge the effectiveness of a particular method or strategy when we have the means to quantify the environment for the time period being measured. For example, was it a trending or a countertrending market environment?
Always Consider Changing Market Conditions
When asked what makes a great trader, Jack Schwager, the brilliant author of Market Wizards and regular interviewer of some of the world’s greatest traders, answered:
“…Great traders are extremely flexible. They can very easily change opinion and go from bullish one moment to bearish the next. So they don’t become wedded to a particular position—they change as they see fit.”
In other words, great traders adjust to changing market conditions, shifting right alongside the market. Identifying changing price patterns or market environments, however, is difficult, and an often-overlooked part of traders’ analysis. By testing in these types of environments, however, it can be determined if there are certain times when a particular trading method works best, and/or if there are methods that can be traded all the time.
The advantage of having a tool to accurately quantify the current market environment (trending/countertrending, or bullish/bearish/sideways) is that strategic adjustments can be made to better suit that particular environment.
Alternatively, a measure of the environment can be factored into the method itself, which then determines whether we are buyers or sellers. This is precisely what we have done with our Risk Tolerance Threshold (RTT) ratio.
As shown on the below EURUSD chart, the RTT ratio breaks down a market into its current patterns over multiple time frames and designates those patterns as “up” or “down” to identify the favored trade direction and capitalize on the scalable nature of markets.
The RTT ratio essentially eliminates the need to change between multiple time frames and interpret each one in order to gauge and confirm the direction of tradable patterns. The tactic behind it is simple: Take any three successive patterns and employ a method that either buys dips or sells rallies in the same direction as the majority of those three patterns.
The actual price levels we focus on for buy or sell set-ups are very specific and based on a tenet of Dow Theory. In the above example, we are trading both the three- through ten-day patterns, and the five- through 25-day patterns.
Therefore, we would be buying dips based on the three- through ten-day patterns because the majority of these patterns (two out of three) is bullish. Conversely, we would be selling rallies based on the five- through 25-day patterns because the majority of these three patterns is bullish. The actual buy and sell signals have been marked on the above chart.
Based on the RTT ratio, we can say we are in a countertrending or sideways market where it makes sense to be trading both long and short, as compared to a trending environment where we would be more inclined to trade only with the trend.
Not only does the RTT ratio take the guesswork out of determining which way to trade, but it gives a static measure of market environment that allows for the capture the statistical data about a method or trading plan in the context of surrounding market conditions. At the same time, it is also a dynamic framework in live markets that can be used to filter current trade signals. And, like the best traders and trading systems, it shifts as the market shifts.
By measuring patterns with a uniform framework such as the RTT ratio, traders capitalize on an excellent analytical tool that balances out decision making, lends well to statistical validation, and also provides a filter for real-time trade signals.
In conclusion, when evaluating the universe of available trading indicators, perhaps traders would be better served using tools that measure actual patterns created by groups of bars or candles, rather than those that simply measure individual bars and candles.
By Jay Norris, Director of Education, Trading University
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.