Entry

Trading Systems - How do I backtest the right way?

Apr 22nd, 2008 23:54
Blog Heal, Taksh Verdhan, Sakir Ali, link builder, Markus Heitkoetter, http://www.free-trading-info.com

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IMO backtesting can be a very powerful tool if used correctly.
The problem is that many trader over-use the functions provided by the 
different backtesting software packages and think more is better. Many 
so-called system developers try to imply that the longer you backtest 
the better and more robust your system will be. That's not always true.
Let me use the e-mini S&P as an example. In 2000 the average daily 
range was 100-150 ticks per day; in 2004 it was only 40-60 ticks per 
day. If you backtest any trend-following daytrading system in the e-
mini S&P you will see that it worked perfectly until 2002 and then 
suddenly falls apart. It seems that there are no more intraday trends. 
That's not surprising as the daily range of the e-mini S&P decreased 
by more than 50%.
What happened?
There are a couple of reasons. Probably the most important one is the 
introduction of the Pattern Day Trading Rule in August and September 
2001by the NYSE and NASD: If a trader executes four or more day trades 
within a five business day period then he must maintain a minimum 
equity of $25,000 in his margin account at all times. Because of this 
rule made traders stopped daytrading equities and started trading the 
e-mini S&P future instead.
Look at the sudden increase in volume in the e-mini S&P in the 
beginning of 2001:
Many of these stock daytraders used methods to scalp the market for a 
few penny. Using the e-mini S&P they suddenly had a much higher 
leverage, paying less commissions, and their methods were extremely 
profitable.
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Unfortunately these scalping methods kill an intraday trend almost 
instantly, making almost every trend-following approach fail.
Another reason for the dramatic change of the market was the 
introduction of the automated strategy execution in TradeStation. In 
2002 TradeStation's customers who were using this feature increased by 
268%. Overbought/Oversold strategies became very popular and when the 
market made an attempt to trend these strategies immediately 
established a contrary position.
Conclusion
When backtesting you need to know these things. It's not enough to 
just run a system on as much data as possible; it's important to know 
the underlying market conditions.
In non-trending markets like the e-mini S&P you need to use trend-
fading systems, and in trending markets like commodities you should 
use trend-follwing methods.
And that's when clever backtesting helps you:
If your backtesting tells you that a trend-following method worked in 
2000-2002, but doesn't work in 2003 and 2004 then you should not use 
this strategy right now.And vice versa: When you see that a trend-
fading method produced nice profits in 2003, 2004 and 2005, then trade 
it.
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I haven't yet seen a strategy that works in all market conditions: 
trending and non-trending. Usually a strategy works very well in ONE 
market condition (e.g. trending) and produces small losses in the 
OTHER market condition. That's why you need to alter trading 
strategies.
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And THAT'S where backtesting can help you. :-)
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