Back-Testing

Each trading system has to have an edge. The edge is what should make your system have positive expectancy. In other words it must be profitable over the long run. We will go into the calculations and common misconceptions about expectancy later. But for now it is just important to understand that an edge should ideally make the system profitable in the long run and make you more likely to make money than lose money over a large enough sample size of trades.

Indicator Co-linearity

When selecting an edge it is very crucial not to over-optimize or fit the data. One common mistake that people make when developing a system is using 2 confirming indicators and optimizing them. This causes the system to look great historically; however the system will not do as well in the future.

Indicators are broken down into 5 types:

• Trend
• Volume
• Overbought/Oversold
• Momentum
• Volatility

Examples

System Robustness

It is also important that the edge is robust. A system is robust when it maintains positive expectancy. The system should be tested on an up, down and sideways move. Many trend following systems perform well when the instrument trends but don't do as well when the instrument is in a sideways whipsaw period. It is crucial that the period is taken into account during back testing.

Amount to Back-Test

I recommend back-testing on at least 2000 bars. If you are backtesting a system on the daily charts; I recommend using 10 years. On the intra-day charts I recommend back testing the systems as far back as your data vendor will allow. This is usually 6 months to a year.

Back Testing Programs

It is important to use professional level software with back-testing capabilities when developing your system. To name a few:

Wealth-Lab

Description:

One of the best back testing programs out there; although programming may be difficult as it is in Pascal. There is no phone customer service for wealth-lab either. NCMfx offers programming services at competitive rates, and at tremendous discounts for its existing forex customers.

Features:

Portfolio Back-testing

Risk management Features

System development wizard

URL:

www.wealth-lab.com

Met stock

Description:

Professional level back-testing and analysis software. Metastock offers numerous trading systems and indicators. Metastock has its own language, it may be a bit easier than Wealth-Lab but far more limited. The customer service is good. And there are numerous add ons and plug ins that you can purchase to suite your style of trading. NCMfx offers programming services at competitive rates, and at tremendous discounts for its existing forex customers.

Features:

Numerous indicators

Alexander Nekritin is a professional trader with over 8 years of experience. His specialties include risk management and system development. Alexander is the CEO of www.forexyourself.com, which is a forex introducing broker and education company that helps suite client's needs in forex trading. Alexander has a degree with a concentration in Investment Banking and derivative instruments from Babson College in Massachusetts.