5 phases of backtesting and implementing new ideas

Hello my friends,

today I would like to tell you about my way of backtesting new trading ideas and implementing them in my trading. At first I would like to say that there are many very good ways how to approach this. Some people do their backtesting very thoroughly and they are very analytical in their approach. It takes them very long before they implement new ideas in their trading but when they do they have very accurate statistics and a heap of backtested trades. Some people are the exact opposite. They just look at few examples and start trading their new method straight away. Again – there is no one right way how to do this and every way has it’s pros and cons.

Iam naturally more inclined to be quite thorough in my backtesting. Unfortunatelly there are some disadvantages when you are too thorough. The most significant disadvantage is that backtesting and implementing new ideas takes a lot of time. The more thorough you are the more time it takes and the more time it takes the less trading ideas you can backtest. Knowing this, I found a method that is quite thorough, but also fast and practical. It consists of 5 phases (from rough backtest to full implementation):

Phase 1: rough backtest

When I have a new trading idea I like to know as soon as possible if it is worth something or not. I don’t want to spend days of backtesting just to find out that this particular idea leads nowhere. I make the first rough backtest as simple as I possible- for example I use RRR = 1, I ignore macro news, I don’t look for any confirmation, I don’t require any more confluences and I neglect all sorts of things that influence my trading in my “standard” trading. I want to know roughly in 1-2 hours if this idea is worthy of any further research or if it leads nowhere and it would be a waste of time to look into it any longer. If this phase looks promising I move into phase 2. If not I make some changes in this idea that came to my mind when I was going through it. If not I make some changes in this idea that came to my mind when I was going through it. If I see that this idea is no good at all, I let it go.

Phase 2: thorough backtest

Now you have some very rough backtest that says that it won’t be a complete waste of time to do a thorough analysis and backtesting. In this phase you want to be much more precise and take into account all sorts of rules, confluences and exceptions that occur in your trading. You also want to backtest this idea on more trades and at more different markets, possibly with more different settings.

This phase it about your preferences and how much elaborate (and time consuming) you make it. You need to realize though that it is only a backtest. It will never be like a real trading no matter how much you try and how much time it takes. Even thorough backtest won’t show you for sure whether this new method will be profitable or not. It is crucial that you accept this. I had several systems that had over 70 % winning in a thorough backtest and then failed when I traded them on my real account. You may say that it makes no sense but it is the truth. I am sure you have your own simillar experience with that.

If your new strategy seems profitable after a thorough backtest you can move into Phase 3. If not I suggest you think about your strategy and make some changes. Don’t discard it! It passed through rough backtest, there is still hope it could work if you make some adjustments. After you made these adjustments repeat the thorough backtest again with these adjustments. If it fails again, give it a few more tries. Only after that I suggest to leave this strategy be. I also suggest you keep your old backtests, even the ones that didn’t go well. After some time time you may have a great idea on how to upgrade/adjust them.

Phase 3: micro trading

I bet phase 3 for lot of people would be demo trading. Not for me. Trading demo and real account are two quite different things. Don’t waste your time on trading demo! I suggest you find a broker that allows you to trade very small positions (mini, micro lots) with good spreads/commissions. I suggest you trade this new strategy with really small volumes for some time. My tip for you guys is: don’t do this with extremely small volumes. The reason is that if you do, you probably wouldn’t care at all about your positions and you want to feel little excitement for the psychology to work. You can use for example 10-20 % of your “normal” position size. So if you normally trade with 1 lot, use 0.1 – 0.2 lot.

This phase is quite crucial because for the first time you trade your new strategy with real money. The question is: when to move further to phase 5? My advice is to take your time because you want to test your strategy in all sorts of market conditions and situations. You want to experience good trading periods and also series of losses. Don’t dump the strategy if the first 5-10 trades were losses and don’t move to phase 4 if you started and immediatelly had a winning series of 10 consecutive trades. Just take your time and see how the strategy performs. If you see that it fails (in a long run) i suggest you make some adjustments and return to phase 2. if it proves profitable (in a long run) go to phase 4.

Phase 4: half positions

In this phase I already know that I have a good profitable strategy. I don’t make any changes and only concentrate on good execution of my trades. I trade with roughly 50 % of my “normal” volume size. The reason is that the strategy is still new and now is the first time I trade it with some considerable volumes. Psychological factors are much stronger and I also need to practise good trade execution. There still can be some little mistakes made (due to psychological factors or bad execution of the trades). Before moving to Phase 4 you absolutelly need to eliminate those.

In this phase I keep detailed track of results. I want them to be comparable to the results of Phase 3.

I move to phase 5 only after these 3 conditions are met:

  1. I traded using this strategy long enough and with simillar results as in phase 3,
  2. I trade it flawlessly (I eliminated psychological factors that messed the trades and I don’t make even the smallest mistakes in trade executions)
  3. I made enough money with it that I can psychically withstand series of losses with full trading volumes.

Phase 5: full positions

Now the training is over and it is time to fight! Phase 5 is no longer a “testing” phase. Here I use my normal trading position size. It happens quite often that when you start this phase you get few losses right in the beginning (cold shower). You should be prepared for it though and you should continue with your trading with full position sizes. I call it a trial by fire. My experience is that only if you make it through this – your first real series of losses (with full position sizes) you are really ready. Withstanding a series of losses is one of the hardest parts of this whole thing – at least for me. You need to remind yourselves – you made it through phases 1-4, your strategy is good and probably had a bad time now. Every strategy has it from time to time. Only if your strategy is losing in the long term you should go back to phase 4 and if it doesn’t help, move to phase 2 or 3. Don’t dump it, just make some adjustments and make it profitable again.

Summary:

The main points of this approach are:

  1. don’t waste too much time and do only a very rough and fast backtest in the beginning.
  2. do a thorough backtest only after you see that your new idea looks promising
  3. after backtest, go straight to trading your idea on a real account
  4. increase your position size in three steps.

I hope you found this article usefull guys. I think this approach is much more efficient than the usual “backtest – demo – full positions – fail” cycle.

I hope to see you all in phase 5!

Take care and happy trading!

Dale

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