Forward Testing by Martha Stokes, CMT
A Solution To Backtesting
A simple technique, it can reveal the true profit or loss
capabilities of a trading system.
Backtesting has been popular among traders for many
years. The concept is that you take a set number of
months or years and test a trading strategy over that
periodís data. You calculate the average results and performance of that trading strategy as it performed during that
time. In theory this sounds like a fantastic tool for traders ó
backtest and know if the strategy works. But that is not what
backtesting this way actually gives a trader.
WHAT EXACTLY IS IT?
Backtesting can be defined in two popular ways:
1. The process of optimizing a trading strategy using historical data and then seeing whether it has predictive
validity on current data.
2. The process of testing a trading strategy on prior time
periods. Instead of applying a strategy for the time
period forward, which could take years, a trader can
do a simulation of his or her trading strategy on
relevant past data in order to gauge its effectiveness.
Most technical analysis strategies are tested with this
approach. At first glance, it makes sense. Go backward,
pretend youíre using your strategy or system on a historical
chart and see what would happen. Sounds good, right?
Unfortunately, there are problems ó inherent and significant
ó that cause backtesting to fail.
Backtesting a trading strategy or system does not take into account whether a market is in an uptrend, downtrend, or
sideways trend. It does not determine what market condition
is prevailing during current trading. Therefore, a trader has no
way to determine and apply the correct market condition to
the backtested time period. The results of the backtested
period are averaged to give you a profit to loss ratio for that
trading strategy. An average of historical data over several
years doesnít give you the facts you need about a systemís
viability and true potential profitability.