What is back testing? Why back test?
I see all these turds on TV talk about what could happen… Oh no, the price of bread could skyrocket tomorrow!!! If I was a bett’n man, I would go buy bread right now!!!
What the crap, man?!?! Who in their right mind believes a word of anything these ‘financial news’ channels spit out?
Number one. If you can not have a historical record of what has worked in the past, then there is zero way to know whether it has even a small chance of working in the future. For instance, let us pretend I go to buy a computer in North Korea and tell this guy, ” Hey you better buy now or the price will skyrocket!” Why should he believe me? No one there buys computers (except the military) and they have no idea if or when they will be allowed to buy them in the future. There is no historical back test to see what has happened in the past, therefor it is impossible to even speculate what may or may not happen in the future.
So let us look at financial TV again. What is Joe Talkyhead screams, “Buy buy buy!!!!” about 1000 companies out there. Do you think anyone could possibly know which way price is going, especially about thousands of different companies? I think you would have to be close to god like in order to hold all that info. Financial TV is all about ratings just like any other TV company.
So what about Mr. Chart Reader on the internet that runs his own signals group? How relevant is he? Well it depends…
1. Does he have a verified track record of some sort? This doesn’t mean he is posting excel sheets. This means verified.
2. Does he have back tested results from the way he trades?
The reason I ask these 2 questions is that if he has verified results, that’s good. The question you need to ask though is how can they be verified? Is he lucky or does he have a system?
The question about back tested results can show a lot. It can actually show you the periods of time when systems work the best and times when to stay out of the market.
Profitable systems do not break in a day. They start breaking down over time so making lots of money goes to making some money goes to breaking even over a long long time period which will give clues to traders to start becoming wary of a system. A profitable system (over the long run) does NOT break in a day.
Humans are creatures of habit. We continue to do the same things over and over in life. Take my family for instance. Here is our routine..
1. We wake up, eat breakfast, shower, go to work or school.
3. we all gather at the dinner table after work/school and talk about our day
4. We do some type of family activity
5. Boy goes to bed and my wife and I watch an episode of our favorite show
6. When sleepy time comes, we go to bed
Now the above scenario plays out a bit different on the weekends but come monday morning, this is our normal routine. Would it be safe to say that this routine would stop altogether overnight? Are we going to just one day change the entire routine?
Nope. One day, maybe we stop eating at the dinner table and start eating on the couch (you know, cause ‘murika!) Highly unlikely but possible. Then the next week, maybe we stop doing a family activity and start sitting by ourselves in the corner each evening. (again…highly unlikely) but one thing is for certain… we will not stop doing our routine overnight. It will break down over time and we can see it coming a mile away.
Since we, humans, are creatures of habit, do we still have habits when it comes to trading? You bet your dollar we do! I have a routine in the way I trade every day. I sit down at my desk and do things in a planned out manner and trade the same way every single day. I am only one person; one trader. If traders are just normal people and do the same things day after day, tugging and pulling the market up and down; then its a pretty safe bet to say that every trader will not change overnight; and that’s what it would take to break a profitable trading strategy. (So sorry to my high school english teach for that run-on sentence.)
Back testing allows you to see what people have been doing. It allows you to see the frequency of things happening in the markets. This gives you an edge. For instance… If you see that every day at 9am, price goes a certain direction 80-85% of the time, and it has been doing this for years and years, what is the likely hood of it still continuing today?
It is very likely!
Ok now what if, the likely hood (or probability) starts to go down. Maybe next month, the back tests show 78% of the time over the past year that price has done this thing. Maybe in a few months, the back tests show that 73% of the time…. Maybe a year from now, back tests show that 67% of the time… I f your strategy is going to stop working, You can see it coming.
Now take a fly by night, seat of the pants trader and tell me why they are winning and how they can calculate it. They can’t! If it can not be calculated in some form, leave and run the other way.
If you would like to see how we do it, just visit joaquintrading.com