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How to Overcome Limitations of Trading System Backtesting

Updated on 2012-11-30 by Guest

Backtesting has always been one of the popular means of testing if a trading system works. Traders spent countless hours to subject their devised system of trading to historical set of data to check if the system works. Considerable amount of time and effort are spent with the goal of checking if a particular strategy produces profit - albeit theoretically - using past market movements and conditions.

Traders, by necessity, have to constantly refine their system by studying charts, past market movements, patterns, indicators, and just about anything that can give you the edge in your trading. You always have to check market inefficiencies and look for ways to maximize profits while reducing risks. Thatís why backtesting strategies is one of the most logical initial step in devising a trading system.

Although backtesting certainly gives a level of credibility to a trading system and gives the traders some confidence that the system were proven to work, it has its limitations. Here are some shortcomings that no amount of back testing can address:

Stock market dynamics constantly change

Back testing may seem like an initial good step towards cementing the efficacy of a trading system, but youíd be surprised at the number of professional traders who donít back test their strategies. One of the reasons they donít is that using historical data will in no way tell you if the strategy work in future market condition.

Itís trading wisdom to realize that you canít really expect the market to react and move in the exact same pattern of the past. And while it helps to study past market movements and reaction, seasoned traders argue that back testing does not give them fresh insights. After all, looking at past charts could tell them the same thing.

Lastly, factors that may have affected the marketís movement in the past may have no relevance in its present dynamics. Thatís why some traders are wary of back testing since factors from the past may no longer have any bearing in the present and all it does is create an illusion of certainty which we all know does not exist in a free market.

It does little in preparing the trader to handle the nuances and adverse market movements.
Analyzing and interpreting data is just one part of becoming a successful trader. Most often, the challenge of trading lies in the mental and emotional discipline of the trader. Managing risks, getting out of a position to minimize losses, weathering adverse market conditions, and facing all raging emotions through all that, are the aspects of trading that no amount of back testing can prepare a trader for.

When you are back testing, thereís no real risk involved so emotions does not get in the way. The cutthroat world of live trading is far removed from the safe environment of trading using historical data. Itís a world where one bad call can cause you your entire account.

How to Approach a New Strategy to Overcome these Limitations?

Back testing certainly has its place in devising trading strategies. However, due to its limitations discussed above, it can be very lacking if you depend solely on it to establish the efficacy of a given strategy.

To overcome the limitations presented in back testing trading systems, traders have to get their feet wet and test the strategy in an actual trade. Thereís no two ways about it. Back testing is the ideal world Ė sort of a trading utopia; while live trading is the actual world that tells whether your strategy is the gold that itís purported to be Ė or a piece of crap thatís best left in the past where it worked splendidly.

The best way to get started on trading a new strategy is to keep the leverage small and the possible losses affordable. After all, losing is inevitable in trading and losing affordable amount of money in testing a new strategy may be the best way to go as it can be a vital part of the learning and tweaking process.

While thereís logic in back testing a new strategy, testing how it performs using real money, in actual market conditions, where real possibility of losing and winning exists can a trader substantiate the solidity of a trading system. After all, no matter which way you try to look at it, risk is always an inherent factor in trading Ė whether you test your system using back testing strategies or use actual trades. But testing the performance of your strategy using live trading is a calculated risk thatís worth the reward.

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Trading financial instruments, including foreign exchange on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in financial instruments or foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and seek advice from an independent financial advisor if you have any doubts.