There’s a scene in a pretty obscure Albert Brooks movie called Defending Your Life where Brooks’ character, who dies in a freak car wreck, wants to get into heaven. But first he has to plead his case before a panel of angels.
Brooks plays a pretty likeable guy who’s made a slew of dumb life choices. Like deciding not to invest in Seiko when the stock was worthless, buying cute cars that don’t run, and not fighting for higher salaries he deserved.
It’s funny to watch Brooks get slammed by the angels, mostly because the situations he finds himself in are familiar on some level. “Bad Decision Brooks” is actually a lot like most of us.
We can easily spot something fishy when looking back. But when we’re in the moment, we don’t always get it right. Especially when we’re trading.
But what if we could get our trades right? Not just some of the time, but most of the time?
We can, by backtesting.
We can easily spot something fishy when looking back. But when we’re in the moment, we don’t always get it right.
Backtesting? What’s that?
No, friends, backtesting isn’t some weird exercise the Pilates trainer asks you to do when you’ve got back issues. Backtesting is a hugely helpful trading tool we’ve added to our algorithmic trading app, Tekton, to let you test your trades before you actually make them.
Tekton’s backtesting feature lets you actually see your trades play out against real historical data using the rules you set for any strategy you want. When Tekton’s done crunching the numbers, you’ll have a pretty good idea of how well your planned trade is actually going to perform live.
If that’s still not making you jump for joy, try this. If Bad Decision Brooks had backtested with Tekton, he’d have known to buy that Seiko stock and to hold out against his boss for an extra ten grand.
How backtesting works
The idea behind backtesting is simple. If a strategy worked once, it will probably work again. If a strategy flopped, it’s a good bet it will flop again.
Why is this important?
Most of the time, we’re so hung up on winning, we don’t even consider what our failures can teach us. If you backtest with Tekton, you can learn from everything, even the trades that don’t work. Tekton will break down your trades stat by stat so you can easily pinpoint the weaknesses in your strategies and fix them. Stats include:
- Profits and losses (how many pips you gain or lose with your trades)
- Averages (the average gain and average loss)
- Ratios (your wins-to-losses ratio)
- Drawdowns (the difference between the highest and lowest points in your trading account balance)
Pro tip: Drawdown is something you’ve got to keep your eye on all the time because when the gulf between your wins and losses gets too deep, you’re either on a roll or you’re in some serious trouble. Tekton keeps a log of all your drawdowns. But it does something even better. It shows you your average consecutive wins and losses, so you can start separating the signal from the static.
Drawdown is something you’ve got to keep your eye on all the time because when the gulf between your wins and losses gets too deep, you’re either on a roll or you’re in some serious trouble.
A Tekton backtesting playbook
Trading thoughts aren’t magic. They can’t make you a successful trader all by themselves. But they can help you master your impulses, even when you’ve already gone algo and most of your bad habits are behind you anyway.
The first thing to do is identify your personal issues or obstacles. Most of these will be leftovers from your manual trading days. Whenever one of those pain points resurfaces, pick the trading thought that will best keep you focused. Repeat it, even if your friends and family think you’ve gone bonkers.
The next step is to go algo. As we’ve said over and over again, the market isn’t afraid of anyone or anything. But the combination of your tested trading thoughts and smart algotrading software that’s always disciplined and focused will make it a lot less scary.
Every good thing has rules and guidelines. Here are the most important ones to pay attention to when you’re backtesting with Tekton:
- Market conditions and trends are relative and usually aren’t good predictors over short time periods. So don’t backtest strategies over a few months. Test long over variable market scenarios so you can see how your strategies play out over time and under different market conditions.
- Instruments count. Major currency pairs aren’t going to give you the same numbers as minor pairs because factors like spread are going to fluctuate, sometimes considerably.
- Don’t backtest without considering volatility measures, especially for leveraged accounts, which usually have fixed margin levels that will be enforced by brokers. As a general rule of thumb, you should steer away from volatile positions. You’ll reduce your risk (see below) and manoeuver more confidently in and out of trades.
- Remember that risk exposure is a double-edged sword. Trading big means either bigger profits or bigger losses. Likewise, playing it safe might save you from taking a serious dive, but you won’t fill your wallet that way. The takeaway? When you backtest, always pay attention to sizing, because it’s the key to successful money and risk management.
- Get to know your average gains/losses. Tekton allows you to figure out average gains by dividing the number of pips gained by the number of wins gained, (or vice-versa for your losses.) With better average gains and a stronger wins-to-losses ratio, you can take larger positions and cut down on commission costs.
Test long over variable market scenarios so you can see how your strategies play out over time and under different market conditions.
The bottom line
Backtesting might not have helped Albert Brooks get into heaven, and it’s not 100% infallible. Like just about everything in life, including start-ups and car engines, past performance can never fully predict how something’s going to actually perform in the here-and-now.
But backtesting can give you an incredible edge when you trade live. Which is why we made it a major feature of Tekton and why we wanted to give you a special peek under the hood.
When you pay attention to key stats and keep a few basic rules of thumb in mind, backtesting will help you build better, smarter strategies by showing you where your technical and theoretical weaknesses are.
But better than that, backtesting will make you a more confident trader, so that when you are ready to trade live, you can put your Red Bull away and close your laptop and actually do something to make your back feel better.
Like Pilates. Or the pub. Your call.
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