Day Trading Strategy Testing

Weve previously underscored multiple times the importance of having a solid trading strategy when your hard-earned money is at stake, which you need to stick to at times of confusion or panic. However, in order to fully rely on your trading system to a point where you wont question it after an unexpectedly long losing streak, it would need to be comprehensively tested and also applied for enough time, so that fluctuations in its results are ironed out. In the current article we will discuss the process of pre-testing, simulating and after-testing your trading strategy.

Backtesting a trading system

Obviously the first part of incorporating a trading strategy is choosing one. There is no universal strategy as each trader must select one that will best suit his goals and risk profile, and then fine-tune it to achieve the best performance. After a strategy has been chosen, its performance must be measured before the real trading starts. The first step of the testing is called backtesting.

Backtesting is a method of evaluating a trading strategy by running it via special software through a database of historic securities prices to determine whether it would have achieved return and whether it would be enough. The test includes variables such as position size, leverage and commissions, and yields results informing you on win-loss ratios, returns etc. You can then use this information to further tweak the trading strategy and run it again through the testing software.

The test itself requires a certain number of variables, starting with the asset and the buy pattern, and you can then further expand the test by adding leverage and other additional data. Most backtesting software can help you optimize your trading strategy by suggesting position size, holding period and other parameters that will yield better risk/reward ratio. Another useful thing about this type of programs is that it requires specific instructions to be inserted. If the trading strategy however becomes too complicated to be tested out by a backtesting software, then it is surely too complicated to be carried out by you.

Testing the strategy live

Having chosen your trading strategy and successfully backtested it via the specialized software, the next step is to try it out in live trading. Even though the tests might have achieved satisfying results, you should initially abstain from committing real money. Instead, you can either monitor the market and write down in a spreadsheet where you would have entered and exited the market, or better yet – you can use a demo account.

Most reputable brokers give full access to demo accounts to test the service they are providing. It wouldnt be wise for a trader to deposit money with a brokerage firm whos technical performance he has not tested. Moreover, most brokers have either proprietary trading platforms, whose layout may greatly differ, while others use white-label products and customize them, thus prompting the need of testing. Although you might not be in for the platform assessment, you can use that opportunity to test your trading strategy for free. Also, demo accounts with most brokers can be used indefinitely, allowing you to extensively run tests and yield results stripped of volatility. If you want to learn more on why demo accounts are good for you, read the article “Advantages of Using a Demo Account“.

Trading logbook

As the trader begins testing his strategy on a demo account, he should put a lot of effort into tracking his trades and building a detailed data base of his position entries and exits. Keeping such a logbook is done best by using spreadsheet software, such as Microsoft Excel, Apache OpenOffice etc. If you want to read more on trading journals, check out the article “Why are Trading Journals Important“.

There are many ways you can organize your journal, but the most basic form should include entry price, time of entry, position size, exit price, time of exit, total proceeds, commissions, gain/loss of position. Another useful addition would be a calculation of your sessions net result after you exit the last trade.

Having estimated your daily performance, you can then make a profit and loss statement for the whole month. It should reflect the starting capital in each day, the net profit or loss in absolute value and in percentage, and the ending capital. You can then calculate your monthly income and to be more comprehensive you can break those numbers into daily and hourly earnings.

Apart from the purely numerical data, you should also write down why you have entered a trade, why you have closed your position and generally any other thoughts related to your trading session. This will help you better evaluate your decision making at the end of the day.