Backtesting is a very important activity that goes hand-in-hand with journaling. You could even go so far as to say that backtesting sets apart good traders, from great traders.
But, what is it?
It is the process of using data you’ve collected in a meaningful way to improve your trading performance. Think of it as journaling on steroids.
Why is backtesting so important?
2 reasons; (a) fine-tuning, (b) broader perspective.
Let’s break it down…
We talked about these concepts briefly in Journaling 101 — but they’re worth mentioning again. Journaling every single position will not only keep you accountable, but it will allow you to use this data to further your understanding of the markets and your strategies. Armed with this information, you can then take it a step further and begin backtesting to fine-tune your trading approach, and focus on the finer details.
As an example, in my online Trading MasterClass, I teach a strategy called the Initial Breakout. I first learned this strategy near the beginning of my trading journey, but soon realized it wasn’t really a strategy. It was simply a price action pattern that would repeat over, and over again. The pattern worked, but the strategy itself was lacking in criteria. And so, my backtesting journey began…
I took all of the trades that I had already recorded and analyzed from my basic journal (as explained in Journaling 101) and started to analyze the data from a backtesting perspective (with the end goal of fine-tuning that specific strategy). What initially prompted this investigation, was a pattern that I was seeing on the 4H chart which triggered me to dig deeper.
Now, keep in mind that if I did not already have a comprehensive journal of all of my past trades, this backtesting journey would have been much more time intensive. Always ensure your journal is up to date and includes as much information as possible. This will save you a lot of time if you do decide to go back and backtest a specific strategy later.
Below you will see the exact process I followed and the positive results that came from it.
Step by step breakdown:
- Filter your existing journal to include only the trades that fall under the specific strategy you wish to focus on (in my case, it was the Initial Breakout strategy).
- Select from your journal, the first position you will analyze, and find the corresponding screenshot (see Journaling 101 for reference).
- Hone in on the details — in my case, I was focusing specifically on the 4H price action as this timeframe was what initially triggered my desire to dig deeper — record your findings (i.e. price rejected the 4H 50EMA and because of this the trade failed).
- Continue doing this with every single trade that falls under the specific strategy you’re focused on & make clear + comprehensive notes.
- Once you have all of the data recorded, it will be easier to spot overall patterns & therefore create more detailed rules / criteria for the strategy (my findings allowed me to further categorize the Initial Breakout strategy into 3 different variations – A, B, & C. This clearly showed me which variation has a higher strike rate so I could then place more focus on that).
The above is a simple example showing you how backtesting can improve your performance and assist you in fine-tuning your strategies. I followed the exact same process when I was working to improve all of my other trading strategies — another example being the Advanced Breakout. I was able to add further criteria to this specific strategy after going through the backtesting process, because I discovered that it will have a much higher strike rate when high-volume is present in the market. Without having the data and analyzing it from a broader backtesting perspective, it would have been impossible for me to improve and fine-tune those strategies.
Also note – you can use the same process but instead, focus on improving things such as stop placement, targets, entry etc.
My advice to you is this: never make a change to your trading plan without first journaling & backtesting. Otherwise, you’re making blind decisions without having the data to back it up… this never ends well. Follow the simple steps above and ensure you’re consistently journaling & backtesting to improve your performance.