If you’re just getting started in the markets you may have seen terminology such as backtesting & journalling floating about, but may be a little confused as to what these are and how they impact trading.
When I first started out, I couldn’t find any valuable source of information to find out what backtesting was and how to actually do it - hopefully this provides an insight and some value to you.
Backtesting is a method for measuring the performance of a Trading Strategy.
There’s actually quite a few reasons why backtesting is so beneficial:
Discover probability and strike-rate of a strategy
Fine-tune your strategy - entry, management & confluences
Practising a skill - Technical Analysis and Trading boils down to being a skill, a skill that can be learnt and practised. I like to use the analogy of a Driving Range for golf. Backtesting can be considered practising your swings - the more you do it the more it becomes engrained in your muscle memory.
I’ve seen ridiculous comments on YouTube and Instagram stating backtesting is a waste of time and a laughable activity. I would avoid listening to these people, no doubt they’re too lazy to perform the required activities that surround trading and becoming successful.
The overall aim of backtesting is as mentioned to collect data surrounding your strategy.
Let’s just take a broad example (not a real scenario);
Through 5 years of data on EURUSD, you’ve discovered that a Bear Flag has a 90% success rate if the structure is comprised of 2 Tops and 2 Bottoms and taken as a Risk Entry (from the Second Bottom). On the other hand, a Bear Flag with 2 Bottoms and only 1 Top taken as a Reduced Risk Entry (on the break of the lows) yields a 20% success rate.
Within a live market environment, avoiding the second scenario and only taking the first would have a positive impact on your results and quarterly returns.
If you knew based on data, that there was an 80% failure rate, would you not find that information useful to avoid taking a trade?
Knowing that - Do you think backtesting is a waste of time?
Now you know the why, let’s talk about what you should be backtesting.
What should you be backtesting?
You won’t like the answer, but it’s completely up to you!
My aim is to provide you with a basic blueprint to at least get you started, but understand backtesting can be an endless activity.
Within Falcon the strategy we are taught is based around Market Structure and Patterns within them. I’ll be basing my examples of backtesting around this but it can be interpreted to any strategy.
At this point I’ll just be showing what to backtest, I’ll discuss the process of how in the next section.
With the knowledge I have know and the power of hindsight, I would recommend the following process for at least getting started with backtesting.
I believe the most important thing is to always approach backtesting with a plan for your sessions. Backtesting isn’t really a one-time-deal. Anything that is going to be added into the Trading Plan should be heavily backtested before applying to the live markets.
Initially backtesting at least 2 years of data on each currency pair the broad strategy (no emphasis on Higher Probability Setups). Tracking Data within Google Sheets but also making notes against behaviour and unique nuances against each pair within Evernote.
From backtesting results, create a filtered list of currency pairs based on accuracy of Trading Strategy with them.
Backtest specific variations of various patterns within setups.
Backtest filtered list with a focus on High Probability Setups - using Bar Replay mode on Trading View to ‘test’ oneself against strategy while tracking data.
Develop Trading Plan based on Backtesting results - focusing on 80% Mechanical and 20% Discretionary
Backtest against Trading Plan to ‘test’ oneself.
Backtest ‘Management’ Styles - Trailing Stop Placement, Manual Exits etc.
Backtest last quarter (every quarter) against Trading Plan to ‘evolve with the market’ and improve Trading Plan.
Now the HOW
The power of backtesting comes from both the ‘doing’ and being present in backtesting (remember the Golf Range) and also crunching the data.
I personally perform manual backtesting on Trading View - I demonstrate how I approach this in the below video.
Tracking & Crunching
I was recently asked the question on Instagram - “what should I do with the data you’ve collected when backtesting”
Without analysing the data and doing something with it, you will be ignoring an important aspect of backtesting.
This is why it’s important to have a firm grasp of your strategy before starting so you can log the variations in setups to be able to quantify data.
I’ve shared below a snapshot of my basic Backtesting Spreadsheet I’ve been using for Q1 2019, as you can see I like to KISS (Keep is Simple Stupid).
The purpose of this backtesting session has been to test the High Probability Setups with an emphasis on Daily Structure over the First Quarter of 2019. I’m then focusing on setups that have returned over 3:1 R:R (highlighted) to begin further analysis on a separate sheet tab.
Further on the right, I am measuring further metrics which I haven’t included in view.
The general metrics you can see though are:
Returns based on days of the week
Best & Worst performing day
% Return for Buy vs Sell
As you can see, my worst performing day has been a Tuesday - interestingly prior to this session my worst performing day was a Monday in 2017 & 2018!
Further metrics to give you an example are:
Highest / Lowest % Return on Patterns
Highest / Lowest % Return on number of touches within patterns
You will also notice I include screenshots for all timeframes, I feel this is especially in important when putting an emphasis on Top Down Analysis approach for Higher Probability setups.
To wrap this post off, I’d like to share some handy formulas I’ve been using to calculate my best/worst days.
I first calculate each individual day of the week return using the below formula:
This means (from left to right): calculate all percentages based on the day of the week matching this column day
Then I calculate the best & best with this formula:
Both of these formulas translate to:
Find the Min/Max of all cells between S16 & Y20.
Hopefully this provides enough value so you know how to at least get started with backtesting.
Approach backtesting with an intent, purpose & goal.
Break your sessions into manageable time blocks. Backtesting can be monotonous and you want to be focusing on quality trades & setups, so ensure you are not burnt out or demotivated. I will do an hour in the morning (from 6:300am) and an hour in the evening.
Track as many metrics as you feel is necessary just ensure you have ‘tracked’ this for each trade to be able to work with the data later.
Remember “If you’re not working on your edge, somebody else is…” @Trader_Dante