Trading Systems  |  JAN 2008

Forward Testing by Martha Stokes, CMT

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 period’s 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 — 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 you’re using your strategy or system on a historical chart and see what would happen. Sounds good, right? Unfortunately, there are problems — inherent and significant — that cause backtesting to fail. The problem: 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 doesn’t give you the facts you need about a system’s viability and true potential profitability.

by Martha Stokes, CMT