Many new traders believe that if they copy the trading strategy of a successful trader, they will be successful too.
Nothing could be further from the truth.
Sure, a proven trading trading strategy is important. But the reality is that there is so much more to profitable trading than just following a formula.
On top of that, there are other factors that many traders do not account for when choosing a trading strategy.
So this tutorial will show you what most traders miss and why trading strategy testing and optimization is so important.
Not All Trading Strategies Actually Work
If a random man walked up to you on the street and told you that he has a trading strategy that will make you rich, would you believe him?
Of course not.
It would probably be smart to see what he has to say, just in case he is telling the truth. But I obviously wouldn't take him at his word.
I would test the strategy rigorously before I ever traded it live.
Yet many new traders take tutorials on the internet at face value and never double check them. I've seen this a lot on forums and on YouTube.
These traders jump from strategy to strategy, never actually testing the strategy, and they wonder why they are never successful.
I call this the Trading Silodrome.
So learning to test a trading strategy is vital to your success.
You need to figure out if the strategy actually works.
A Trading Strategy has to Match Your Personality
The most common reason that new traders fail is because they think successful trading can be boiled down to a simple formula (trading system), and if they just follow the formula, they will be successful.
That's only half of the story.
A profitable trading method is certainly important.
However, the other half of the equation is to be sure that the trading strategy matches your personality.
This is what most traders fail to understand.
So when you backtest a trading strategy, yes it should be profitable. But the most important thing that you can figure out is if it's the right strategy for you.
To put it another way, not everyone likes sports cars. You may like sports cars. But other people prefer trucks, motorcycles, or unfortunately…mini vans, as their primary form of transportation.
Trading strategies are similar in that some traders will prefer trend following strategies and others will prefer countertrend strategies. Some traders will prefer to day trade, while others like long term position trading.
This is because we are all born with different innate preferences and talents.
I think you already understand that in other areas of life. Some that come to mind are:
- Work preferences
- Finding a partner
- Taste in food
- And more…
The problem is that most new traders don't apply that same logic to trading.
They never ask themselves if a trading strategy is something they like to trade or they think they could be good at.
It's like dating. You usually have to go on a few dates before you find someone you get along well with.
Treat trading strategies in the same way and it will dramatically improve your probability of success.
You Need to be Able to Adapt Your Strategy to Changing Market Conditions
The reality of trading is that market conditions can change over time, and you need to be prepared for that.
Events like interest rate changes and monetary policy updates can have an effect on how a trading strategy performs.
I've personally discovered that some trading strategies in Forex don't perform well from 2003 to 2006, but will start to work from about 2007 onward.
You can see an example of how this works on the S&P 500 weekly chart.
There are times of strong trends, big dips and high/low volatility.
Therefore, if you trade the same strategy in all of these different market conditions, there will probably markets where your strategy won't work well.
There may be market conditions where you might actually lose a lot of money.
But when you properly backtest your trading strategy, you can find out when you should use it and when it might be a good idea to just sit on your hands.
This is extremely important because having this knowledge can be the difference between a profitable year and a losing year.
Create a Diversified Portfolio With One Strategy
Here's a tip that not many traders talk about, but can have a huge positive impact on your trading results.
Even if a trading strategy is consistently profitable, there can be parts of the strategy that a trader doesn't like.
For example, let's say that a trading strategy has drawdown periods that are longer than a trader is comfortable with. Whenever this happens, many traders start looking for an entirely new trading strategy.
However, finding a totally new strategy may not be necessary. The downsides of a trading strategy can sometimes be reduced or possibly even eliminated by just tweaking the original strategy a little.
For example, let's say that you have a profitable trading strategy that targets 2R or 2 times risk. So for example, if you risk 100 pips on a trade, you would target 200 pips of profit.
Here's an example of a 2R profit target.
But maybe your win rate with this strategy isn't as high as you would like.
One thing you could do in this case is to test your strategy with a smaller profit target. A good place to start is 1R.
Therefore, you would reduce your take profit from 200 pips to 100 pips, if you had a 100 pip stop loss.
Here's how that would look on a chart.
If you backtest this strategy and it's shown to be profitable, then combine the backtesting results from your existing strategy to see how well they work together.
You might find that 2 versions of the same system, blended together, gives you a return that's better than either of them on their own.
If that happens to be the case, there are a couple of ways that you can combine these strategies:
- You can break up your trades into 2 parts. Take half of your trade with your original system, then take the other half with the modified system. So if you usually take 2% risk on a trade, you could take 2 trades with 1% risk each. You might even consider something like a 80/20 split, if that's possible.
- You can alternate between the 2 strategies. So take your first trade with the original system, the second trade with the tweaked system, the original system on the third trade, etc.
There are other ways to use your new strategy, but those options are a good place to start.
Again, test it out and see what works for you.
Final Thoughts on Testing and Optimizing Trading Strategies
So if you've always thought that backtesting and optimization is unnecessary, I hope that this tutorial has convinced you that testing is one of the most important steps in successful trading.
It's like buying a used car. You're always going to take the car for a test drive to be sure that it works.
In a similar way, you always have to test a trading strategy before you start using it. You need to know if it has an edge or not.
Optimization is also important because it can potentially turn an unprofitable strategy into a profitable one, or make a profitable strategy even more profitable.