This post is written by Jet Toyco, a trader and trading coach.
I’m sure that at some point in your trading journey you’ve heard:
“You must backtest your strategy before risking real money!”
“If you want to save time and money in trading, backtesting is key!”
On the other hand, I’m sure that you’ve also heard that:
“Backtesting doesn’t guarantee future results, stop wasting your time!”
“Forward testing is the key, start trading in real-time as soon as possible!”
So, which one’s correct?
Who should you follow?
Well, the answers to those questions lie in today’s comprehensive trading guide where you’ll learn:
- The unheard reason why backtesting is important (and it’s not about the profits)
- Why you’re backtesting the wrong way as a price action trader
- How to save time and improve your skills fast as a price action trader through proper backtesting
Then let’s get started…
What is backtesting and why is it important
There are many ways in which one trader can backtest his trading strategy, so its definition can vary.
But it all boils down to this…
Backtesting is using historical data to test how your strategy has behaved in the past before you commit real money to it.
It’s performing a thesis by crunching the numbers yourself before graduating to use the strategy in the live markets.
Here’s an example of a backtest report:
This table shows the performance of this strategy every month and every year.
So for example, this system has generated +35.40% for the whole year of 2002, or generated a -3.30% loss at the first month of 2019.
Yes, backtesting doesn’t guarantee future results.
But you wouldn’t want to risk your hard-earned money on using a strategy that didn’t work in the past, right?
So you see, even if backtesting doesn’t guarantee future results…
It gives you a higher probability of achieving favorable results in the future.
Why is backtesting important?
Ah, I’m sure you’ll probably say:
“It’s important because I want to ensure my strategy makes money so that I can make money myself!”
It makes sense, right?
However, if you backtest with the focus of making the most money as much as possible…
Then you’re in for big trouble my man.
Let me explain…
If you look back on my backtesting example, you’ll probably focus on years where the system has made more than +50% a year:
“Wow, a hundred percent in just a year and during a financial crisis? Shut up and take my money!”
Alright, now how about these years:
Imagine trading this strategy for one whole year only to lose -24.30% of your capital, will you start throwing this strategy out of the window?
Imagine trading this strategy for four years straight from 2015 to 2018 only to have breakeven results, will you continue trading this strategy?
Aha, now this makes things more complicated huh.
Now, I want you to scroll back up and read the first paragraph again on what backtesting is.
Notice the word “behave” right?
So you see my friend…
Backtesting isn’t just about making sure your strategy makes money in the long run.
It’s about knowing the behavior of your strategy in the past (winning and losing periods) so that you can cross-check it with your unique risk tolerance as a trader.
That’s the real reason that makes backtesting so important and powerful.
Now, I hate to be the bearer of bad news but…
You won’t be able to reap the benefits of backtesting if you’re doing these two things:
- You backtest manually
- You’re a price action trader
I’ll share with you a remedy to these issues in the following sections.
But for now, let me show you why backtesting by being two of those things can waste your time and money.
Then read on.
Why you’re wasting your time backtesting as a price action trader
Here’s one of our trading systems that have been backtested automatically from 2000 to 2020:
As you can see, you can expect to make 8.79% a year on average.
You’re probably thinking:
“Ew, 8.79% a year? No way I’m going to trade this strategy, let me make some tweaks!”
Sure, feel free to do so!
But if you’re backtesting manually, are you willing to go through 20 years of data and test 300-500 trades without any guarantee that the results will be better?
I don’t think so!
What if you’re trying to backtest as a pure price action trader this time, will it make a difference?
I’m sad to say this but, your backtest results may not be accurate.
Let me prove it to you…
P.S. If you’re interested to learn more about this systematic trading strategy, watch the training video here.
Okay so, in this scenario…
I am going to backtest from 2020 to 2022 on EURUSD on the daily timeframe using pure price action using TradingView’s replay function.
On my first test, I have gained a total of +9.21%:
Great, price action trading works!
Now, what if I perform the same test, will it still be the same?
Nope, very different.
See what I mean?
You can see how I placed my stop loss differently and how I decided to take or skip some trades on the second test.
That’s just the true nature of being a price action trader, not all traders may see the same thing as you, or even yourself when you have a second look!
So with that said, what’s the solution?
If backtesting as a price action trader isn’t accurate, how can you ensure what you’re doing works?
Does that mean price action trading doesn’t work and I should just be a systematic trader instead?
Let me answer them in the next section.
How to backtest properly as a price action trader
If you’re still reading at this point, I can tell you’re a dedicated trader.
Let’s go back to the basics:
“What is price action trading?”
Price action is a trading methodology where you make trading decisions based-off the historical movement process without the aid of indicators.
What’s the most appropriate thing to do if the market is in a range?
You buy low and sell high, of course:
Now, what if the market is on an uptrend?
Why you buy breakouts and trail your stop loss:
Chart too complicated?
No problem, we can skip the trade and stay in cash:
Sounds cool, right?
Being a price action trader means that we constantly flow with the markets.
It’s this exact reason that gives you like a price action trader an edge over systematic traders!
Because being a systems trader means that your strategy is designed to capture one type of market condition.
But being a price action trader gives you the flexibility to try and take advantage of any market conditions!
So, how do you backtest this?
Here’s the answer:
Instead, what you want to test here is not the methodology itself but to test the consistency of your thought process with the methodology!
“Wait what, how does that work coach Jet?”
- Are your plots relevant to the current price?
- Is your trading setup simple and relevant to the current market condition?
- Is there barely any conflicting information about your trade?
Now before I explain each, I highly suggest you check out this amazing article here if you haven’t yet: The Price Action Trading Strategy Guide
Let’s get started…
1. Are your plots relevant to the current price?
If the current market price is here:
There’s no point in plotting every single support & resistance and trend line you see.
Because by the time you get out of your trade, there’s a low chance that price is likely to reach those levels anyway!
Also, having too much “information” on your chart gives you too many unnecessary options when deciding when to enter a trade, therefore degrading the outcome of your trading decisions.
Keep your charts clean and know why your lines are there.
So clean, so good, am I right?
2. Is your trading setup simple and relevant to the current market condition?
After you’ve plotted relevant lines on your chart, what’s next?
Know whether it’s in an uptrend, downtrend, or range.
Looking at GBPJPY on the daily timeframe:
You can see that the price has broken out of its range.
Now, looking at the current price, what is the “current” state of this forex pair?
It’s about to be in an uptrend, so if you want to hop onto the trend, then having a breakout setup can be your superpower:
Want one more example?
Now that’s one choppy market.
But what’s the first thing you should do?
Correct, plot out relevant lines!
Next, what trading setups are appropriate for this kind of market condition?
That’s right, entering on pullbacks (buying at support, and selling at resistance):
There you go!
3. Are there barely any conflicting information about your trade?
To be honest…
You’re all set with the first two.
However, not only you must know when to enter trades, but also how to ignore them.
Yes, in every single chart that you will see, you must have the “walk-away” power.
What does that mean?
It means that when you’re in doubt, you won’t hesitate to stay out and skip the trade (even if it might go in your favor).
Let me share with you an example…
As you can see on USDZAR on the daily timeframe:
You have spotted a nice breakout signal.
However, the price is currently approaching an area of resistance (a place where potential sellers might come in) while the general direction of this market is in a downtrend.
So right now, you can see that there are multiple factors “against” your trading idea.
What do you do?
Correct. Ignore the trade and stay out!
Good trades happen when decisions are made swiftly without hesitation.
So with that said…
How do you “test” this?
Yes, I’ve shared with you a lot of charts today.
But in the real world of trading, every chart you see will greatly vary from each other.
It’s why I’ve shared with you a 3-step framework to make decisions better as a price action trader.
So, as you are now looking at past prices (backtesting) here’s what you need to do next.
Screenshot your trades and review your thought-process
Taking a screenshot as you enter your trade is helpful as it encapsulates your thought process when selecting trades (and also it helps you test the framework that I have shown you).
Each screenshot doesn’t have to be complicated for each trade, it can be as simple as this:
Simple and clean!
Now as a general guideline, I highly suggest you at least:
- Produce more than 100 historical trades with screenshots of your thought process
- A maximum of 10 trades per market (so that you’re able to be exposed to different types of the market)
- Have a trading software or platform that hides prices by default (to avoid being biased)
There you go!
But before I end…
Let me share with you a couple of trading tools that you can use to manually practice the 3-step framework that I’ve shared with you.
Backtesting tools that will help you backtest manually as a price action trader
TradingView is an all-in-one charting platform where you can view the data of thousands of markets without opening a brokerage account.
This platform is the fastest way for you to get started on learning how to trade!
And if you remember, I’ve shared with you how I was able to use it in the second section of this guide.
However, the downside here is that you have to do everything manually.
From applying risk management to reviewing your statistics.
What TradingView does is hide the bars and that’s it!
It does come free of charge though.
If you trade the Forex market then Soft4FX is a great investment.
Not only does it come with reliable historical data, but it even has a historical economic calendar!
At the end of the test, you can see your statistics on how well you fare.
Again, this platform is great if you use MetaTrader 4/5 regularly and trade the forex markets.
Now, what if you’re a stock trader?
Thinkorswim’s OnDemand is a class of its own as you get to trade historical prices of not only one stock, but the whole stock market itself!
It means that you can use Thinkorswim’s versatile stock screener and enter trades as if you are using the platform in real-time.
This feature benefits stock day traders the most.
The downside is that if you’re new to Thinkorswim, there is a steep learning curve to navigating the platform.
Also, you would need to apply for a live trading account first before you are able to use this feature.
That’s pretty much it!
Have you learned something new today?
Let’s have a quick recap of what you’ve just learned.
- When backtesting a strategy, it’s crucial to also determine how the strategy “behaved” in the past, and whether or not it fits your risk appetite as a trader
- Trying to backtest as a price action trader to determine whether or not it makes money can waste your time, as each backtest result cannot be replicated
- As a price action trader, you must put more emphasis on improving your thought process by exercising it through historical data so that you can approach each chart you see objectively
Now, I want to hear your side.
How do you backtest as a price action trader?
Do you even backtest at all?
Let me know your thoughts in the comments below!