WHILE sitting in front of a screen, clicking on buy buttons for stocks that you think are about to turn green and selling the ones that you have a hunch are going to turn red is good fun, it is also a quick way to burn through your cash.
If you still want to be trading in 3 days time, it helps to have a plan. And by back testing this plan using historic market data, you can see how successful your strategy might be. “One of the great things about back testing is that, not only does it allow you to test out strategies in different trading conditions, but it also teaches you to keep records of the good and bad trades – what works and what doesn’t,” says Jamie Blake, sales account manager at Capital Spreads.
Back testing allows you to test rules on where you set your stop losses, at what point to enter and exit a trade, and how big the stake is you want to use on each trade. It also encourages traders to take an academic approach to their trading – recording, testing and reviewing their trading activity – allowing them to learn from any mistakes and replicate successes.
A number of spread betting platforms have functions that allow you to back test your strategy – clients can set rules and run them over historic data
There are also third party programs that allow traders to see how their plans would work with real life data. For example, with the online trading strategy system Zignals, the process goes through five steps. Firstly set up the starting capital and exit conditions. Next select the stocks, and set the rules; then run the back test and finally publish the strategy.
The theory behind back testing your strategy is that something that would have worked in the past should work in the future, but as Manoj Ladwa, senior trader for ETX Capital, puts it: “When back testing strategies, it is advisable to not fit the strategy according to the data. Any strategy worth the paper it’s written on needs to be robust and be applied to all market conditions.” The key is to design your strategy and then test it with the data, rather than knowing what your data set looks like and jigging your strategy to suit.
The quality and relevance of your data is also key – rubbish in equals rubbish out. Similarly, if you are testing a strategy for the coming weeks by using data from a mid-90s bull market, you are not going to be accurately modeling for the current financial climate.
Back testing can serve as an important part of your overall trading strategy, making you more confident that your plan will achieve the desired results. It can help to iron out any technical flaws and as a result make you a more profitable trader. However, you should always bear in mind the caveat that past performance does not indicate future results. “The key thing is to find a market that you are comfortable with, work out whether you’d like more volatility, longer trading hours and how the chosen market will be affected by different data releases and then test your strategies while bearing that in mind,” says Blake. But he adds: “I think everyone would agree that hindsight is a great thing, but only a mystic ball will tell you what’s coming in the future.”