How to Test Trading Strategies
Back-testing is using data from the past to test whether your trading system is effective or not. Back-testing is one of the most important things you can do for verifying that it is a viable system. With today's technology, it doesn't have to take long, but should cover at least 10 years worth of data. After you've back-tested your system, you will have greater confidence it works and will be able to weather the draw downs much better.
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Instructions
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Choose a software. Two of the best softwares for back-testing are AmiBroker and TradeStation. These both allow you to test your technical trading ideas with data that can go back 10 years or more. TradeStation will even allow you to use fundamental data to test your ideas.
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Back-test at least 200 to 300 trades. While the number of years you back-test is not so important, how many trades you test are what counts. The more trades involved, the more statistically valid it becomes. A minimum of 200 to 300 trades are necessary, but 500 to 600 are better.
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Create a report. Once you have successfully back-tested a system, your software will create a report. This report should include a few key things such as profit/loss, number of un/successful trades, consecutive days down, total number of trades, biggest draw down/profits and biggest losing/winning streak.
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Test the system in both bull and bear markets. Make sure to test your system during different types of markets including, trending and sideways markets just to make sure it is valid in all conditions.
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Paper trade. Once you have successfully back-tested the system, paper trade it for two to three months to ensure there are no unexpected glitches you did not account for. Also, this will take into account the broker fees.
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Don't forget about your stop-loss when testing. Some systems test well and have a high winning percentage of trades, because they don't use a stop loss. However, one big loss can take away all those gains. Create parameters using a stop-loss such as 2 percent on each trade.
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