Trade Secrets: The Art of the Back Test

By: Jimmy Cox

The art of the back test will stop you trading in the dark and give you the opportunity to make the wife and kids (heck! even Warren Buffet) proud. Stop being the naive trader that is going to come crashing down and lose more than they can afford. As I've mentioned before, one of the things I really love about trading is that, unlike any other business, you can fully test your 'business model' (trading plan) without risking any real money. In trading, this assessment process is called back testing.

The back test is an area most missed by traders. I've talked about the importance of psychology and money management in previous chapters - and so have a lot of other trading coaches. So much so, there is now a bevy of information and awareness around. You only have to surf the 'net to see just how much focus is placed on these areas - as there should be. But all this attention seems to be at the expense of the back test. As a result, back testing, I think, has now become the new least understood and appreciated area of trading.

A Back test is most important because it directly impacts on your entries and exits, money management and psychology in the following ways.

- Entries and exits - back testing enables you to test your entire system's performance using historical data. With that information, you can make the necessary adjustments to produce the results you're looking for.

- Money management - back testing allows you to test various money management models to see which works best with your system.

- Psychology - as discussed earlier in the book, understanding your system's strengths and weaknesses - even if they are only on paper - will improve your trading confidence. This will have untold effect on your performance when you begin to trade for real.

Whatever technical analysis criterion you use to trade with - be it moving averages, candle sticks, volatility breakouts, Fibonacci retracements or any other trading system - you're going to need to back test it thoroughly, in order to remove any possible doubt about it's capability.

Without back testing, a lack of confidence arises and usually forces traders to question their own trading systems. They give in to the temptation to modify their trading plan... often with devastating consequences. This temptation typically spawns from a string of losing trades or an opportunity to replace their trading system with a new whiz-bang indicator that is the latest fad talked about in chat forums.

Anything that sounds too good to be true will attract the attention of a trader who is not satisfied with his trading system, simply because he has not properly tested his system in the first place. He has not built up the necessary confidence needed to successfully trade the system he has developed.

The back test ensures you know where you are trading at and how effective your system is.

Article Source: http://yourfinance.co.za