There are many trading strategies available on the internet. But how do you know if a trading strategy is profitable or not?
A trading strategy is considered profitable if it has a positive result in backtesting and/or forward testing. The results have to meet the return requirements of the trader, and go through a series of filters to be sure that the results are an accurate representation of real world trading conditions.
That's a mouthful, so I'll break down everything in this tutorial.
I'll get into how to define a profitable strategy and how to do the testing to figure out the performance of a trading strategy.
Then you'll put those 2 elements together to find out if a trading strategy really is profitable or not.
The fastest way to figure out if a rules-based trading strategy is profitable is to backtest it.
Backtesting can be done in any trading market.
When you can see that a trading strategy has a profitable track record over a long period of time, that's the best indication that a strategy is likely to work now and in the future.
Some people think that you need to know how to code a computer program to backtest.
That's simply not true.
You can do both manual and automated backtesting.
Anyone can backtest.
This software makes manual backtesting easy.
You can also use free charting platforms to backtest.
It's just a matter of which one is easier for you.
All profitable traders look for trading strategies that have a historical edge in the markets.
Once you've proven that a strategy would have been profitable in the past, you'll also have key data on how that strategy performs.
You'll know things like…
- The maximum number of losing trades in a row
- The average monthly return
- The biggest drawdown
- Market conditions when the strategy works and when it doesn't
- And more
All of these data points allow you to make important decisions about the trading strategy, which I'll get into more detail later in this tutorial.
Think about cars…
We all know that certain makes and models of cars last a long time and others break down quickly.
The reason we know this is because we have historical data that shows the reliability of these cars.
For example, Toyotas are generally very reliable cars.
On the other hand, Fiats are notoriously unreliable. So much so, that many people say that Fiat stands for “Fix It Again Tony.”
If you purchased a car from a company that just started producing cars last year, you wouldn't know how reliable those cars are because they don't have a track record.
So you're taking a big risk.
In a similar way, you need to know the track record of a trading strategy before you risk real money.
Again, backtesting is the best way to do that.
If you've never backtested before, this beginner's guide will show you how to get started and the best tools that you can use.
Backtesting also gives you one of the most important traits that a trader can have…resiliance.
When you take a trade, you have a high level of confidence of your probability of having a winning trade.
You won't know exactly how each individual trade will work out.
But you'll know that if you take a lot of trades, X% of your trades will be profitable.
The fastest way find that X% probability and your expected return is through backtesting.
Knowing the backtesting statistics of a trading strategy also helps you when you're on a losing streak.
All trading strategies will have a losing streaks, but you want to be able to separate a normal losing streak from a situation where your trading strategy may have stopped working.
For example, let's say that you had a maximum of 7 losing trades in a row in your backtesting.
That's normal for that strategy.
But when some traders start trading live, they freak out when they have 3 losing trades in a row and think that their system is broken.
If they have backtesting data and they reviewed their maximum losing trades in a row, they would realize that 3 losing trades in a row is well within the normal parameters of the strategy.
There's nothing to be worried about.
The same thing goes for the other data points you get in backtesting.
Therefore, having this data gives you the confidence to keep trading when you hit a rough patch.
Another way to figure out if a trading strategy is profitable is to forward test it.
This basically means that you open a demo account or “paper trade” to build a track record on a trading strategy.
Never risk real money when forward testing.
The primary advantage of forward testing is that you'll know if a trading strategy works right now, in real-time.
On the downside, it can take a long time to collect enough data to determine if a trading strategy works or not.
I see so many new traders making the mistake of forward testing a trading strategy that they just learned, with real money and a full-sized account.
They believe that a trading strategy works because someone told them that it works.
Then they wonder why they lose money.
Never take someone's word that a strategy works, always test and verify.
If you're only going to forward test, then you need to have enough trades to give you confidence that a strategy is profitable.
Some people online say that the minimum number of trades that you need to have a properly tested system is 100 trades.
That's not true.
I talk about how to figure out the minimum number of trades in this video.
The video talks about backtesting, but the same concept applies to forward testing.
Alright, once you have a number of trades that you're comfortable with, then it's time to move on to the verification stage.
Double Check the Results
Once you have data on your trading strategy and it's profitable, then it's time to take a step back and consider if you're missing anything.
There can be assumptions that you made in testing that would not carry over to live trading.
For example, if you use data from Broker A, then you start trading live with Broker B, you might get very different results.
The reason is because the Forex market is decentralized.
So each individual broker has slightly different price quotes.
Historical data will affect lower timeframe strategies more. The slight difference in quotes usually won't have a huge effect on trading systems on the daily chart or above.
But shorter term trading strategies are more sensitive to differences in quotes because the margin for error is much smaller.
Stop losses and take profits are smaller and therefore, any deviation in price will have a larger effect on the profit and loss of every trade.
Another common thing that people overlook in testing is the spread.
This is especially true in backtesting.
If you don't factor in the spread on every trade, your strategy will look much more profitable that it would actually be in live trading.
You might think that this is common sense, but you would be surprised at how many people overlook this.
But don't stop at these 2 examples. Think of all of the things that could be different between your testing and live market conditions.
Once you're satisfied that your testing results are a good representation of live trading conditions, then it's time to ask yourself an important question…
Figure Out YOUR Definition of Profitable
Now we get into the big question…
What's your definition of profitable?
That might seem easy to answer, but it's not.
I'll start with an extreme example to illustrate my point.
Let's say that you backtested a trading strategy over a 20 year period and it made a total of 5%.
So if you started with $10,000, your total profit would be $500, or an average of $25 pear year.
Is the trading strategy profitable?
But is it profitable enough to make a living on?
Therefore, I would not consider that trading system profitable.
I would lose money on that trading strategy, when I factor in the profit that the system produces in relation to the amount of time that I would have to spend on it.
So there are a few elements to consider when creating your definition of profitable.
- Average return per year
- Amount of time you'll spend trading the system
- Risk of ruin
- Real world performance
It's all a matter of what's important to you, how much risk you're willing to accept and the return you want to make.
Everyone would love to make 800% per year, but could you handle the risk that came with that return?
For most people, the answer is no.
That brings us to another important question…
How Much can You Realistically Expect to Make Per Year in Trading?
When you first get into trading, it can be tough to know what's possible in terms of consistently and return per year.
So the best way to figure this out is to look for as many data points as possible.
Listen to interviews with professional traders.
Take a look at track records of trading systems that are similar to the one you're testing.
That will give you an idea of what's possible and probable.
…and it will give you more confidence.
That's the complete guide on how to figure out if a trading strategy is profitable or not.
As you can see, the idea of “profitable” is very much a relative term.
What you think is an acceptable level of profit could be very different from what I consider acceptable.
You also have to factor in the risk and consistently of the strategy.
So first define the amount of profit you want get out of your live trading strategies.
Ask yourself if that number seems realistic, based on what you've seen from live trading results of similar strategies.
Then test the trading strategy so you have as much data about the strategy as possible.
From there, simply compare the results of your testing with what you feel is an acceptable return.
In real world trading, there is no magic profit number.
It's up to you to make the call.
If a trading strategy meets your criteria, then the next step is to open a small live account and start trading the strategy.
Trade the strategy for a few months to see if your live trading results are similar to your testing results.
Only move the strategy into a full-sized account after it performs well in the small account.
Alright, that's your blueprint, now get to work!