I have a confession to make – I never used to backtest, ever. Blame it on my ignorance. First, I had no idea what it was. Second, when I did learn about the concept, I didn’t fully grasp its benefits. And third, I really didn’t know how to do it.
Then, I started getting more systematic in my trading and necessity demanded I shed my ignorance and figure out how to do it. And now, I’m converted! There is no doubt I’m a better trader, and I’m therefore convinced everyone should use backtesting to some extent in their trading. At least, if you want to make money.
In this series of articles we’re going to look at the what, why, and how of backtesting. So buckle up and hold your head still so nothing spills out.
What is Backtesting?
Here’s how Investopedia defines backtesting:
“Backtesting is the process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital. A trader can simulate the trading of a strategy over an appropriate period of time and analyze the results for the levels of profitability and risk.”
Here’s how I would explain it to the layman. Hey, Jimmy! Before you risk your hard-earned money buying options straddles in Microsoft stock every month, wouldn’t you like to know if that particular trading strategy even generates a profit? Of course, you do! So backtest it! Create a set of rules, complete with entry, management, and exit rules. Add in position sizing and go back and see how that system performed over the past six months or two or five years or whatever.
Why Should I Backtest?
I can think of numerous benefits to the exercise.
First, it tells you if your system has made money over time. I’m assuming that’s your premise. Otherwise, you wouldn’t have crafted the system in the first place. Apparently, you think your strategy has an edge (i.e., should make money) so put it to the test. If it doesn’t, in fact, earn money over the backtest then you can either modify the rules and try to improve the performance, or scrap it. Better to figure all that out before committing your capital, right?
Second, it tells you what to expect. It is imperative when you begin any new strategy or system that you understand exactly what you’re signing up for. Think of a stock investor who plows a bunch of money into the S&P 500 and then two years in a bear market strikes, and he sees his beloved portfolio drop 30%. Disgusted he abandons ship and sells everything at the lows. Then when the market recovers without him, he swears off stock investing. Here’s what I would ask this investor: What did you expect? Were you not aware that bear markets are commonplace? That the stock market drops 30% once or twice a decade? It’s the nature of the beast, friend!
If he would have taken the time to understand the history of the market, then perhaps he would have succeeded. This is what backtesting can do! It can tell you what’s typical with your strategy. What’s the typical loss? What’s the typical gain? How often do you usually lose? What’s the longest losing streak?
If you know the totality of potential outcomes – at least those experienced over your backtest – then you are better equipped to weather the ups and downs of the system moving forward.
Just as someone socking money away in a retirement account better understand the volatility and average returns of stocks, bonds, and any other asset class they’re investing in, an iron condor or covered call trader better understand the expected volatility and returns they will face. Otherwise, they’ll probably buy or sell at the exact wrong time!
Third, it provides the confidence you will need to stay the course during losing periods. Traders who don’t take the time to build a system, let alone backtest it, are quick to give up after losing trades. See if this doesn’t sound familiar. A new shiny strategy catches your eye (let’s say it’s selling Iron Condors on the SPX every month). You try it once or twice on paper, and it works. Then you start trading live. You win one month, two months, then three months. On the fourth month, you lose, giving back all your gains in the process. In frustration, you vow never to trade condors again. Then you search for a new strategy. Rinse, wash, repeat. Because you had no context, no understanding of what was typical. You were quick to quit.
I know traders who have missed out on thousands of dollars this year because they quit trading the Cash Flow Condors system after last November’s election caused them to have a losing month. Do you know why? Because they had no context nor confidence. They hadn’t personally done a backtest and simply didn’t trust the strategy to work anymore. Essentially, the first time it got hot in the kitchen they bailed.
With a backtest I know just how hot it can get in the kitchen. I’ve obsessed over the temperature gauge for a long enough period to know it inside and out. I know what type of clothes to wear, the appropriate apron. I know how the food will taste on a good day and a bad day. Consequently, I’m rarely, if ever surprised. Do you see how that would make you a better trader?
Those are three big WHYS for backtesting. Next time we’ll take an in-depth look at WHAT goes into building a system and HOW to backtest it.
Financial freedom is a journey
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