Step-By-Step Guide to Back-Testing Your Trading Strategy

The performance may look great on paper, but make sure you're accounting for all the variables!

So what exactly is back-testing? Simply stated, it's the process of testing a trading strategy using historical data. There are a few factors to consider, especially to achieve the most accurate results, but don't worry: I'll show you how it all works in a few simple steps: 1. Use a large enough sample of historical data to back-test properly Back-testing a strategy properly requires at least one year of historical data, and it's always a good idea to test multiple markets as well. The chart above shows one year of data on a 4 hour chart of Crude Oil. (We used simple trend lines to determine a change in trend and the black boxes are corrections.) 2. Know your strategy rules and follow them closely Note that the chart above is a screenshot of where we planned to enter a position to go long. 3. Test your strategy in all market conditions It's important to note that market conditions change all the time, and that you should test your strategy in both trending and corrective phases. My strategy requires that we identify a trend and trade the end of a correction, which makes it particularly useful in all market conditions. 4. Log your results (good or bad!) Not all trades work out!  Sometimes you'll get your butt kicked, and other times you may miss a trade entirely. Both wins and losses present an opportunity to learn and improve. Keeping a journal is a good way to log your results, and should include every trade outcome within the period you are back-testing. Important note: Assume you were actually there to have taken the trades you're back-testing. Always log results during the times you're most likely to have been present to trade. 5. Note all the metrics of your strategy's performance After you've back-tested your strategy against a substantial amount of historical price action, there should be a clear indication as to whether you actually made a profit or a loss. Other important metrics to consider are:   Did you experience a draw down? How long did it last? What was your average win/loss ratio? What was your average risk vs. reward ratio? Largest amount of winning trades in a row (and the same with your losing trades). Important note: The performance of your strategy may look great on paper, but it doesn't account for emotions. When it's time to trade real money in a live trading environment, you may want to allow for a drop in the strategy's performance of around 5 – 10%. 6. Consider whether your strategy can be tweaked (or scrapped) Always be honest with yourself about your strategy's results. It may be time to tweak your strategy, or scrap it altogether and start over. A big mistake that traders tend to make is changing their strategy rules (or adding more) while they're back-testing, thinking that they can improve its performance. This will lead to unreliable skewed results, so if you need to tweak your strategy - do it BEFORE you start back-testing again! 7. Test your strategy in a simulated account​ When you finally arrive at a strategy that has potential, the next important step should be testing it in a real-time environment, BUT in a simulated account first. Trading with real money immediately is NOT a good idea, and brings with it a whole host of emotions that can undermine your performance. If you can't make money in a simulated account first, it's incredibly unlikely that you'll be able to make it in a live account either. You need to allow yourself time to prove the profitability of your strategy without any real risk. This will give you that added confidence that you'll need when you're ready to go live. Consistency is very important, and it's why most successful traders take months or even years to develop, back-test, and trade their strategies in a simulation account before trading real money. Conclusion The entire process of back-testing is an important step for those who want to develop their own strategies. Some traders, however, simply don't have the time to go through this process and may seek a proven strategy instead. If you haven't had a chance to see my strategy or its performance, you can learn more on the Price Action & Income website. I created a complete curriculum that'll walk you through every step towards being successful - and it's never been easier to get started. You should really give it a look if you're serious about taking your trades to the next level. You won't be disappointed!

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