In today’s episode, you’ll how to tell if you trading strategy works, or not.
So listen to it right away…
Hey, hey, what’s up my friend?
In today’s episode, I want to discuss, how to tell if a trading strategy works or not.
Because I’m sure you had these thoughts in your mind at one point or another:
“Man, does this trading strategy really work? It looks good, but what if I trade it then there’s a series of losses? How do I know if it’s a drawdown or whether it works or not?”
There are a few things I look for in a trading strategy.
And the most important thing is…
1. A trading strategy must be backed by logic
Any trading strategy or system must have some logic behind it.
Take for example, trend-following. What’s the logic behind it? The idea is that you’re trading many markets. And markets trend over time.
Why do markets trend? It’s because of greed and fear. When traders and investors are greedy, the market goes up high over time. When markets are in a recession, when a market’s collapse, there is fear. People will sell and that creates a downtrend.
So market trends over time either uptrend or downtrend. And as a trend follower, we don’t predict. We simply hop on the move:
- If the market breaks up higher, we look to buy and ride the uptrend for as long as possible
- If the market breaks down, we look to short and ride the downtrend for as long as possible
This is why trend-following works. There’s a sound logic behind it.
2. A trading strategy must be backtested
Once you have a logic behind the trading strategy, you’ll have to find out whether the strategy works, based on the historical data.
You can just backtest a simple trend following system and see how it fares over the last 10, 20 years.
If the backtest results work, then there’s a good chance that it could work in the future.
It’s important when doing this type of backtesting, that your system is robust. Let me give you an example.
Let’s say you backtested a trading system or a trend following system and you trade:
- The breakout of the 200-day high
- Across 50 markets
- 5 ATR trailing stop loss
And let’s say that makes money.
However, if you change a parameter let’s say from 200-day break out to 150-day breakout and you realized that trading system loses money in the long run, then you have to be careful – because it tells you that the system is not robust.
So when I trade a system, it has to be robust.
For example, a trend following system that I trade follows the breakout of the 200-day highs. I can change the parameter to 220-day high, 179-day high, it doesn’t matter.
The system in the long run will still make money because it’s robust. It does not have many rules, it’s not being over-optimized. And that’s why it’s pretty darn difficult to break the system down when it’s based by logic – it’s something that you know clearly works.
And this brings me to the third point:
3. A trading strategy’s likelihood of breaking down
What’s the likelihood of the trading strategy breaking down?
When will a trend following system not make money? Well, when there are no trends out there when a market is in a range.
But ask yourself, over the last 10, 15, 20 years, has any market remain in a range forever? Very unlikely. The market is always trending.
When there is a deviation from its value, the market will trend.
When there are fear and panic, the market will trend.
So ask yourself, what is the likelihood of the strategy breaking down? This ties back to the robustness aspect that I spoke about earlier. If you adjust certain parameters, will the strategy break down or will it still hold up?
For example, you can adjust the breakout parameters instead of trading the 200-day breakout, you can trade maybe 181-day breakout and see how does it work?
Instead of having a 5 ATR trailing stop loss, you have 7 ATR trailing stop loss. How does it work?
Instead of trading 50 markets, you have 60 markets. How does it work?
If after adjusting all these parameters and the strategy still makes money in the long run, this tells you that you’re onto something.
This is something that you would have confident trading in the future because it’s a system or a strategy that’s pretty hard to break.
So these are the few things I look for, to tell whether a trading strategy works or not:
- It has to be based on logic to explain why this system should work.
- I would like to do a backtest on it to find out how it has fared over time. If you can’t do a backtest or if you’re a discretionary trader, then you can go with a forward test approach.
- What is the likelihood of the system breaking down? And what is the robustness of the system? If you adjusted the parameters, will the system still hold? Will it still make money?
So that’s it, I’ve come towards the end of today’s episode and I’ll talk to you soon.