How to Tell if a Trading Strategy Works
Do you find yourself flitting from one way of trading to another? Or constantly tweaking the way you are trading, never quite finding that consistent winning streak?
The internet is an amazing thing – there are thousands of trading strategies described in forums, social media and YouTube videos etc. But how do you know if they work? The answer is much simpler than it seems. Test the strategy properly!
A proper test constitutes at least 30 correctly taken live or demo trades. The two elements to this are ’30 trades’ and ‘correctly taken’.
Why do you have to wait for 30 trades?
One of the biggest mistakes that newbie traders make is to give up on a trading strategy after a run of losing trades. The thinking behind doing this is understandable but very wrong. The thought is “If a strategy is losing trades, why keep doing it?” The point is that every trading strategy has losing trades!
There is no perfect system that never loses a trade. (Perhaps with the exception of a High Frequency Trading (HFT) hedge fund that is gaming the system by front-running large trades.) Maybe a trading strategy is very profitable over 30 trades – but just happens to lose 5, maybe even 10 trades in a row.
Sample size is the key
The point is that you need a large enough sample size to be able to judge whether the trading strategy wins more money than it loses. Take this analogy: If you had asked 10 US citizens if they voted for Donald Trump or Hillary Clinton in the 2016 Presidential election and 9 out of 10 people said they voted for Hillary, well why didn’t she win? It’s not enough people to judge how the whole country voted –the sample size is too small.
The same logic applies to a trading system. In fact, 30 is probably not enough trades to really tell – but it gives you a much better idea than a string of 4-5 losing trades that will put off a lot of traders from continuing a strategy they have started using.
What is a ‘correctly taken’ trade?
A trading strategy is defined by a set of rules. It is following these rules that give the system it’s ‘edge’ over a period of time. This edge produces a result that is better than random, and most importantly produces a profit.
It is not a valid test if you don’t follow the rules of the strategy. For example, a trading strategy says you should only place ‘buy’ orders when the price is above the 200 day moving average and only place ‘sell’ trades when price is below the 200 day moving average. If you place a buy trade below the 200 DMA you are basically trading a different system. The result of the trade – whether it is a win or loss – does not tell you anything about the viability of the trading system you are testing.
Don’t beat yourself up if you break the rules of the strategy you are testing. We are all human and make mistakes. The key is to realise that it was a mistake – we will call it an ‘error trade’. This trade does not count as one of the 30 trades. This is especially difficult if the error trade happened to be a winning trade. The best response to an error trade is to move on to the next trading opportunity and try to follow the rules.