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The Idiots Guide To Back Testing For Confidence

After you've set your initial stop loss, chosen your method for calculating your trailing stop loss, and implemented all your money management rules, there is one last thing you should do; you should begin back testing your system. With out back testing you will be headed in the right direction, but you won't know what to expect from your system. Back testing will also give you the confidence to keep going when you begin to experience the doubt that every trader faces at some time. Back testing your system is by applying the rules and conditions ... read more

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After you've set your initial stop loss, chosen your method for calculating 
your trailing stop loss, and implemented all your money management rules, there 
is one last thing you should do; you should begin back testing your system.
With out back testing you will be headed in the right direction, but you 
won't know what to expect from your system. Back testing will also give you the 
confidence to keep going when you begin to experience the doubt that every 
trader faces at some time. 
Back testing your system is by applying the rules and conditions of the 
system to the stock's historical market data. However, this is only possible if 
you're trading a system that is entirely mechanical and does not require any 
human input to place the trades. How do you know whether or not your system is 
completely mechanical for back testing? Can you take down your trading plan, the 
set of rules and guidelines that you follow, and hand that over to someone else, 
who could then trade the same system and receive the same results as you would 
if they followed the system carefully? 
If you can do this, you have a mechanical system that is ready for back 
testing. If you can't, you should look at implementing a completely mechanical 
system. Perhaps one of the hardest parts in trading any system is to have the 
confidence to stick with your system. In fact, a mechanical system almost forces 
you to make decisions that are in direct conflict with what your gut feeling 
might tell you to do. 
Remember, our gut feeling tells us we should hold on to losing stocks until 
they get to the break even point, and our gut feeling would tell us to sell 
shares as soon as we're a little bit in profit. Obviously, a mechanical system 
goes against these human tendencies, and that is one of the reasons why it's 
psychologically difficult to trade. However, back testing a mechanical system, 
will tell if you it your plan will work or not.
While back testing will not tell you with 100% accuracy what the 
profitability of your system will be once you start trading it, it will give you 
a very good sense of what you can expect. All prices are driven by the same two 
factors, supply and demand, in the present and in the past. So, even though 
price movements are never going to be exactly the same, in your back testing you 
will see the patterns, and similar movements that show up over time. With back 
testing you can discover the how profitable you system is likely to be, and how 
often you are likely to have a loss rather than a profit. 
Back testing your system over different market conditions, it can be 
reasonable to draw parallels as to the performance of your system historically 
to its performance trading it in real time. Knowing this, because of back 
testing, will make it much easier to stick with your system, and the profits you 
can realistically skyrocket.

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