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
| Indicator Type | Example | Example |
| Trend | Moving Averages | ADX |
| Volume | On Balance Volume | Accumulation/Distribution |
| Volatility | Bollinger Bands | Keltner Bands |
| Momentum | Stochastics | Rate of Change |
| Overbought/Oversold | CCI | RSI |
|
|
|
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. You can contact Alexander with further
questions at alexn@forexyourself.com.
