How to Backtest Trading Strategies

In order to trade like a robot, you will need to generate a set of rules and follow them religiously. Backtesting a trading strategy is the key to being a profitable trader. There are five steps to backtesting a strategy in order to determine if your rules are solid enough to go the distance.

robot trader

Steps to Backtesting a Trading Strategy

Decide on Trading Rules

The first thing you have to do is decide on what your rules will be. Are you trend trading? Are you swing trading? Or are you scalp trading?

Trend Trading

I’m sure you’ve heard the phrase “the trend is your friend”. Long term trend traders benefit from large moves but they have to be willing to stomach the short term price action that might move against them.

Technicals to Use for Trend Trading

If you are trading long term you will want to use technical indicators that are best fitted to long term charts. Moving averages and Fibonacci sequences work best on long term trades.

Swing Trading

Swing trades are generally a shorter time frame than trend trading but longer than scalping. The time frame could be between a few days to a few weeks depending on the swing that you are trading.

Technicals to Use for Swing Trading

For these medium term trades, you can use almost any technical. Stochastics could work but you will want a volume indicator along with it to determine the strength of the oscillator signal. A heiken ashi chart is a nice addition to a swing traders arsenal.

Scalp Trading

Scalpers are traders who are in and out quickly, in minutes, seconds or ticks. They generally go in with a preset stop and limit and are riding the volatility.

Technicals to Use for Scalp Trading

Candlesticks are great for scalpers and using the Parabolic Sar to scalp would work as well. These indicators reflect price changes quickly and allow for fast action.

Backtest Your Rules

The next step is to backtest your rules. Write them down and select a chart time frame. Then figure out each time your rule was met, what price you would have entered and exited and your potential profit or loss. This is the most labor intensive but most important part of backtesting a strategy. Make sure you are honest with your rules and the data.

Revise if Necessary

If your rules do not make it through the first time run through a backtest, then revise them. Change one thing, change everything but make sure you keep testing and revising until you are happy with the outcome. A good rule of thumb is winning 51% of all trades with the rules you came up with.

Paper Trade Your Trading Rules

Once your rules make it through the tests and you are confident in them, you will need to paper trade your rules. Open a demo account and test the rules over a number of days and in different trading conditions. Make sure you stick with paper trading for a while until you see that your rules are solid.

Live Trade Your Strategy

When you make it through paper trading in a demo account you are ready to live trade your rules. Open a new trading account and start making money!

Photo Credits: http://www.bankrollmob.com/poker-news/20101020/american-programmed-own-poker-robot-won-220-00

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Comments

Rad McHaley says:

June 28, 2011 at 1:54 pm

There is actually a really interesting blog that hits on backtesting. The author of the blog posts a very simple rule based strategy that is profitable but not good enough to trade as is. With comments and inputs from users he enhances the strategy and then posts the backtested results for everyone to see. It’s pretty cool.

http://www.backtesters.blogspot.com

- misswallstreet says:
  
  June 29, 2011 at 1:39 am
  
  Thanks for stopping by!