Trading By The Numbers by Sami Khan
Many traders are happy to backtest their trading systems,
but how often do they study the statistics behind their
trading setups prior to implementing a strategy? Hereís a
look at how taking this step can help determine whether itís
worth developing a trading system based on an idea.
When you make a decision, chances are you will look
at what happened the last time to see what to expect
this time. For example, you would avoid traveling on
a route to work that has been congested in the past, or
you would avoid eating foods that you havenít liked before.
Similarly, if you are looking to trade based on a trading system,
you would want to see past information about the system.
Typically, this would be done by performing a backtest.
Are backtests the best action to take?
Letís take a step back. For simplicity, say the system you
are considering will have long-only entries, and you have a
well defined setup. Before performing a complete backtest of
trades, ask yourself, ďWhen I have seen this setup in the past,
did the price usually go up afterward?Ē
Note that Iím not talking about actual trades taken here ó
Iím talking about understanding the typical price distribution
after a setup has occurred.
For this long-only system to be of any interest, price must
have usually gone up after the setup. But what does it mean
to say that price must have usually gone up? Fortunately,
these days, there are huge amounts of financial data available,
making it easy to find when the setup has occurred in
the past. After locating an occurrence, you can look forward
in the data and sample subsequent price action. Then you can perform a standard statistical test
to see whether it is statistically sound
to say that price is likely to go up after