7 Steps How Traders can Test New Trading Systems

January 29, 2017 06:00

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Dear Traders,

Did you ever run into a long list of questions before and after you test a trading system?

Maybe you wondered what critical factor deserves the most attention? Or perhaps you asked yourself, what is the most efficient road map for testing purposes?

Then this guide is for you because our goal is for you to learn how to test a new trading system with a step-by-step approach.

The steps are intended to help a trader receive sturdy feedback on their trading system as quickly as possible. The feedback loop should be short yet valuable.

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Step 1: inspiration via screening time

Watching and monitoring price action on the charts is a great first step to ignite inspiration and creativity for an effective trading system. This " charting time" allows traders to familiarise themselves with the financial markets of their choice, such as Forex, CFD or commodity markets.

Sooner or later, patterns usually become visible and you can finally test them out. However, no need to worry if creativity falters—you can always join our live webinars where Nenad and I mention dozens of trading ideas.

Step 2: backtest quickly

Once an idea is generated, I always test the rough parameters of the trade system in the past. I will scroll back on the charts and start calculating how such a setup would work out.

Please note that this is the 'old-fashioned' way. An easier method would be automated testing, which is available via MT4 Supreme Edition. It will help you learn how to backtest an MT4 trading strategy properly.

For instance, Nenad's article earlier this week mentioned the T89 pattern. You could take the rough idea and check its performance on the EUR/USD 1-hour chart during last month or the USD/JPY 4-hour chart of last year.

This is the time to find a niche. However, don't spend too much time on this step. Note down quickly 40 trades and move on. This step is just to receive a first, initial feedback from the market whether it has a potential feasibility (success). If this fails, we need to return to step 1.

Step 3: write down the trade system

Words are powerful. By writing down the idea on paper (or in an electronic device), I force myself to formulate the exact system rules. I will run into the trap of hindsight bias if rules only remain in my mind.

Be aware—I aim for easy trading system rules at the start, not for endless rules and exceptions. There is no need to elaborate extensively on all aspects - just make sure to capture the core. Another tip is to divide the ideas into critical parts and add-ons, as a way to split importance.

With the initial parameters known and logged, it is to time to execute the actual live testing with a demo account. This is the phase where traders want to spend most of their time because live trading (even on a demo) requires much more discipline and patience than back testing.

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Step 4: demo trade intensively

Opponents of demo trading will say that nothing beats trading with live capital. This is true: the trading psychology will not be tested in the same way.

Nonetheless, traders will receive vital information about the system in actual trading (not backtesting), such as these 6 data points:

  1. equity curve
  2. win versus loss ratio
  3. average win vs average loss
  4. average length of trade
  5. for math fans—distribution of the results and the T-statistic (which calculates the luck factor)
  6. your own feedback and sentiment.

The goal is to test at least 40 trade setups, as quickly as possible. Why 40? This number is statistically large enough to be able to make a first, early judgement within the quickest time frame possible.

The first 5 points are plain numbers, but point 6 is equally important—emotions. Do you enjoy trading this system? Do you feel comfortable with executing the trading plan? If you answer all of the above with "no", then it could be time to go back to the drawing board (step 1).

Step 5: be very patient

At this stage, I noticed that traders easily get trapped in various problems:

  1. a cycle of continuous optimizations (stay in step 4)
  2. the urge to try a new trading system (back to step 1).

The key to moving from step 4 to step 6 is patience, discipline and persistence.

1. Optimisations

There is nothing wrong with adjusting the trading system with important modifications and retesting those changes in another round of step 4. The best solution is to find a middle way. Try to limit this to one or two times, otherwise the loop could be never ending.

Also, don't forget to note down the changes in your trading plan.

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2. New system

Giving up on the current trading system to test a new trading idea is often tempting, too. The problem is that trading systems are never perfect. Choose the one that suits you and stay patient as you walk through the learning curve.

Traders tend to give up (too) early on trading systems, but time is needed to understand all of the details, plus ins and outs. This is valid too if you decide to learn a trading system from another trader.

A trading friend of Nenad and myself, for instance, almost gave up on our trading system. However, he carefully followed the learning process and surprised himself by achieving fantastic results (he was so happy). Job well done for staying patient and going through the learning curve which each system embodies.

Step 6: test live with risk management

At this point, the trader has adjusted the trading system for improvements and preferences, and has gone through cycles of feedback and learning.

It is time to place the hard work into motion and test the trading system in live trading. Keep the following factors in mind:

  1. implement the trading plan
  2. implement a robust and sturdy risk management plan
  3. limit losses to a very acceptable level (lower risk for first 40 trades)
  4. write down all feedback before, during and after the trades.

It is critical to keep learning from these 4 steps. The risk management and trading psychology factors cannot be compared to demo trading. Hence, it is important to test them in a live environment.

If there are any differences noticeable between the demo trading and live trading results, it is critical to immediately find the potential root cause by reviewing feedback. Another good poifeedback moment is once 40 trades have been taken.

After the first initial 40 trades have shown expected and acceptable results, a slightly higher risk is tolerable. Of course, you should still stay within risk management parameters.

Step 7. Congratulations, you have built a successful and professional trading system. Don't celebrate too soon, though, and keep learning from the feedback process.

Cheers and safe trading,

Chris

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