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Back Testing and Psychology

[Originally posted: Thursday, September 21, 2006 2:00 PM ]

After you have back tested a strategy and have a winning game plan, at least historically, you are ready to put it into action and trade real money.

Before you do this there is a very real and important psychological aspect of this strategy that you should take into account. What happens if the strategy, with real money, starts out on a losing streak?

In order to assess your psychological well being in times like this you should do one of the following. (1) Work-out the start date of the worst draw down / performance period for the back tested data and re-run the back test starting from this date. (2) Manually calculate the number of days from the start of the worst draw down to the most the account would have draw down.

You also need to calculate the number of days from the bottom of the draw down to the point where your account returns back to its original balance and you are now back at break even.

The two dates and the number of calendar (not trading) days between them are very important at this stage of the game.

You now need to sit down and think about the psychological impact that this would have on you if you were trading this strategy in real-time with real-money.

Let's say that the worst that your back-tested strategy did was to draw your account down by 20% over a 5 week period and then 3 weeks after that you were back at break-even.

Ask yourself these questions:

  1. You've been trading for 2 months and your account is exactly where it was. How do you feel that after 2 months of hard work you have earned nothing?

  2. You carefully executed every detail of your plan perfectly for 5 weeks and your account has gone from $100,000 to $80,000. How do you feel?

  3. After 5 weeks, with a 20% loss, you ask yourself: Should I continue with this strategy? (It doesn't appear to be working.)

Remember that in the back tests that you ran this was the worst case scenario that historically happened. This, and worse, could happen when you start trading. The strategy may be a fantastically profitable one when measured on a year by year or on a multiple year basis but do you have the discipline to stay with it if you start it at the beginning of a losing streak?

Moreover, what if you start trading and the losing streak is longer and worse than the worst draw down that you say during testing? At what point do you give up on the strategy and throw in the towel?

These are important questions that you need to ask and have answers ready for before you place your first trade. Knowing the answers to these questions and being prepared for the worst case scenario will allow you to focus on your strategy knowing what can happen and what you will do in the event that it does happen.

You know where fire extinguisher is in your house but you never expect to have to use it or to lose everything in a house-fire, however, you know exactly what you'll do if that ever happens. You'll get your family out the house and extinguish the fire if you can.

When trading a strategy you obviously do not expect it to lose money in the long run but if you kick it off on the wrong day then be prepared for the worst.
Following straight on from the previous blog posting about Back Testing and Psychology we could, in some strategies, finesse when we start trading them.

If, in back testing, we discover that our strategy is profitable overall but every now and then it goes through a losing streak of 3 to 5 weeks.

We could paper trade the system until we see a 3 week loss and then kick it off with real money. Although there is no guarantee that this will be at the beginning of a winning streak it's an interesting theory that I believe requires more investigation.
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