Back-Testing Strategy

Back-Testing Strategy: 1.8 Billion Ways to Improve Your Trades

By Dean Albrecht, Contributing Editor
Tuesday, December 6, 2005: Issue #264

As the editor of a trading service, I’ve got a pretty big responsibility to generate hefty results for my subscribers. And because I need to be confident about the direction of my trades, I make it a point to use as much information as possible. One type of information that consistently generates good results for me is historical data.

Yesterday, the New York Stock Exchange saw nearly 1.8 billion shares change hands, which is pretty close to its average. But over the weeks and months, you’re talking about a ton of information! So, why not use this tome of historical trades to our advantage?

Today, let’s look at how to use recent market data through a back-testing strategy to get an edge in your trading.

The Three Questions “Back-Testing” Can Answer

One of the reasons I trade options is to enjoy the higher percentage gains compared to stocks. But there is also inherently more percentage risk. That’s why back-testing can play an important role. It allows us to put our strategies under the microscope prior to using real money on our ideas.

It’s usually very tedious work – punching loads of buttons, changing parameters and writing codes. But something we get excited about.

How important is back-testing? Well, as I said before, I like to have a pretty good idea about how my trades are likely to go… before I pull the trigger. Then, I’ll run tests in real time to see how the strategies do with real money.

For example, we have an exchange-traded fund (ETF) strategy that we follow quite closely. When we created the system, we knew that the swings in the near-term, in-the-money calls and puts were significant. But we wanted to know the answers to three questions before we put any money on the line:

Will our entries and exits be good?
Will they be high-probability trades, with percentage swings in the options upward of 30%?
At what point do we take our losses and lick our wounds before we lose too much of our capital?

The Back-Testing Strategy = Confidence In Trading

What we ended up creating was a system that is right more than 65% of the time, and has 20% losses once a month and 20% gains two to three times per month. The numbers work, but we didn’t deploy the strategy until we did the back-testing to make sure that our idea had a good chance of winning over the long run.

Once we had the confidence to run the strategy, we deployed it with real money and worked out the real-time kinks, ultimately creating a winning strategy. And back-testing enabled us to do it more quickly.

While we don’t base our whole belief system on back-testing, it can give us substantiated confidence, or at least a shot of reality to keep us out of a bad trade. Either way, we get more than a good idea of where we may end up.

Good Trading,

Dean