Over the years, I’ve seen countless discussions regarding the topic of “back-testing” and whether or not the practice serves its ultimate purpose. Recently, the subject has come up a bit more frequently on this forum so I wanted to share my opinion with others. Plainly put, I feel that “back-testing” is doing more harm than good, and those that tout its effectiveness are coming from a place of not understanding what it means to trade with a professional’s mindset.
First, we need to start w/ a few definitions (as I see them):
Live trading- a brokerage account w/ your own money on the line
Demo trading- a brokerage account w/ fake money on the line
Back-testing- pulling up a price chart, scrolling “back in time”, and applying a technical strategy to paper trade w/ no money on the line, moving forward x bars @ a time
This is my position:
There are practically zero emotions involved: Most traders know that the two most important human emotions to manage while trading are fear and greed. These two emotions are virtually non-existent when demo-trading / back-trading. Why? There is no money on the line. Humans have a deep connection to their money (some may or may not agree w/ this) because it is a representation (for most) of sacrificed time. Time in which they could have been doing something that they enjoy.
In other words, I sacrifice my leisure/hobby time to work in order to obtain money to fund those activities @ some point in the future; that’s the exchange. Thus, a connection is made to that money, and most people won’t simply treat it as if it had no value and blow it on meaningless goods/services.
When these two emotions are removed from the trading process, you’re not “trading”. It’s like trying to run a vehicle w/o a fuel source. Yes, you can put it in neutral and coast down a hill, but you’re not actually driving. There is almost no stress involved b/c your money isn’t on the line. Also, most folks will recommend back-testing on the weekends, which is doing even more harm. The stress of the work-week plays a major factor in your decision making process during live-trading, and you will not be in the same mind state on a Saturday morning as you were on a Wednesday afternoon. The weekend is for relaxing and resetting.
No frame of reference for exposure to differing risk factors: How can you replicate a live trading session, mid-week, where you maybe have some money tied up in a losing trade, and are considering a new position? There is simply no frame of reference to what a live trading environment would be inclusive of: account balance (margin available), recent account performance (are you coming off a string of losses and feeling risk-averse?), and market based event risk (was there a major fundamental shift and the market is hanging on the words of a central bank?).
Subconsciously, you’re going to be aware of event-risk that has already played out and had a major impact on the market. This will impact your ability to analyze and apply a strategy in the past. Markets move on anticipation of an event. Most successful traders will tell you “I don’t care what happened in the past, tell me what’s going to happen in the future”. From a trading perspective, this should make sense.
Subconscious awareness of where price currently is: If you’re back-testing a major pair (say USDJPY) and you haven’t been living under a rock for the last month, you’re 100% aware that the Yen has been gaining strength. Why would you make a bet against this during your back-testing session? Even if you admit it or not, you’re subconsciously going to have a prejudice to the downside.
Building improper technique: Self-generated confidence is crucial to becoming successful. However, self-generated confidence that is a product of an improper and illogical way to interact w/ the markets can do more harm than good. It’s simply not a 1-1 relationship (in terms of applying the “back-testing” strategy to a live market environment) for the above mentioned reasons (no emotional attachment, no frame of reference for risk, a subconscious bias).
Under stressful environments, the body will revert to a previous state of comfort known as muscle memory. The brain is a muscle. By back-testing, you’re improperly working out your brain and under live stressful conditions you will revert back to that moment of false confidence and sabotage yourself.
Back-testing has little-to-no value for technical traders: This is the conclusion. The fact that if you’re trying to interact w/ the market in a technical-only-manner, you simply cannot apply what you learned during back-testing to a live market environment. This does not mean that patterns, support/resistance, other relevant price action elements are irrelevant- that is not what I’m saying here. What I’m getting @ is- Yes, patterns, support/resistance, other price action elements are relevant, but they are meaningless without the existence of emotion, risk-tolerance, a connection to live funds, and the unknown aspect of future price movements.
All of the above-mentioned play a major role in the decision making process during live trading.
If you feel the need to “practice”:
Use a demo account, under live market conditions
Forex Tester 2- not perfect, but a major upgrade from back-testing
Review prior conducted tech analysis and live trades
Read up about other traders w/ success stories
Take a break! Resetting the mind for a few days (away from the charts) is necessary to avoid burning out
Looking forward to comments.