How to Know if a Strategy Works
The sure-fire way to know a trading strategy works, is to start using it and watch your account steadily grow. But how do we know if a strategy is going to work before we put money into it?
Well, we can’t know for sure what will happen; but we can try to reduce the risk by eliminating things that clearly don’t work.
This is what backtesting is for. And while you’ll find loads of articles recommending you backtest a strategy before implementing it, there aren’t so many that tell you what a successful backtest looks like.
We Have to Make Things Personal
The major reason that experts won’t tell you what a successful strategy looks like is that trading is quite personal. What defines success for one person does not define it for another.
So, depending on your style of trading, only you can be the judge of your trading success.
If I declare the criteria for what a great trading strategy is for me, it might not work for you at all, and you’re going to be very unhappy with me.
You may be thinking: but arent there any basic guidelines for backtesting? Pointers? Tips? Anything?
Sure, there are. But, be warned; there’s math involved. We just had to get over the caveat that all trading is personal and that suggestions for what counts as a successful trading strategy can vary.
Trying to Not be Vague
How do you know you’ve backtested a strategy enough? It’s a good question!
Backtesting is an often repeated suggestion, but no one tells you how far back you should go, or how much of it you should do. The thing is, the more you backtest, the better you are; there is no such thing as too much backtesting.
Basically, right now – have you backtested? If you have, do you have some free time? Great! Do some more backtesting.
Generally, you want to go through the entirety of the cycle that could impact the security you will be trading.
For example, there are reports that come out once a month that will impact the general trend of a currency pair, so you want to be able to backtest through that entire cycle, and avoid the potential coincidence that your strategy only works when a certain data comes in a certain way. So, that would be a minimum – and the more time you have your trades open, the further back you want to test.
No trading strategy will ever give you a 100% success rate – if it does, there is something fishy.
You can have relatively high success rates given specific circumstances (usually with trading that requires very small moves, and that often comes with a high money management risk), but success rates for most professional traders fluctuate between 55-60%. That might sound a bit low, but the idea here is that your winning trades make more than your losing ones.
So, you shouldn’t be too disappointed if you have a strategy that gives you positive trades 60+% of the time. Now, whether this is good or not will slightly depend on your money management strategy.
Remember that a successful trade isn’t one where you got a signal that the market would go in a certain direction, and then the market did; you have to track it to conclusion. You have to consider the entry signal and the exit point, and then determine whether the trade was a success according to your plan.
The bottom line is that a successful trader has a trading plan in place based on realistic expectations of the capabilities of the market; and then compares their strategy of choice against that plan.