I hope you’re well after a long Labor Day weekend!
In our last issue, we began breaking down the second key to a winning trade plan…
Which is to backtest and forward test your strategy.
Now, we mainly focused on backtesting last time…
And before we move on to the third and final key to a winning trade plan, we need to talk more about forward testing and cover some words of caution regarding both forward and backtesting.
Now, you may be more familiar with forward testing than you are with backtesting, even if you’ve never heard it referred to as “forward testing” before.
Forward testing is where you actually trade your plan following all the rules in a live market…
Except that the trades are executed in a simulated (sim) account.
See, backtesting helps you dial in your strategy…
But forward testing is where you get to prove whether the work you did in backtesting paid off or not.
Simulated trading — a.k.a. forward testing — is a great way to build confidence in your strategy and your ability to execute it under live market conditions.
Now, one of the keys to successful forward testing is keeping detailed records.
You need to log everything that happens during each trading session, so that you can remember later as you’re tweaking and refining your strategy.
Another major key to forward testing is that you are not putting any real money into the markets!
This is what makes sim trading so beneficial.
It allows you to trade in real time under real market conditions… without putting any real money on the line.
Now, some folks will tell you that this is precisely what makes sim trading not beneficial.
They say that there’s no way to replicate the emotions that come with putting actual money on the line during a real trade.
However… I disagree.
You see, the mind is an extremely powerful tool.
And the reality is that if you approach your forward testing with the same mindset that you would approach a live trade with, you’d be surprised at how realistic it really can feel.
Now, there are some things you need to watch out for as you backtest and forward test your plan.
First, don’t backtest over extremely long periods of time relative to your timeframe.
For example, if you trade on the 5 minute timeframe, don’t backtest two years of data.
It’s simply not going to help you.
Second, be careful of over-optimizing your plan while backtesting.
If you recall, last time we said that when you select a period of historical data to backtest, you should divide it into thirds.
Two-thirds of the data will be your “in-sample data,” which you’ll use to run your trade plan and tweak, alter and optimize the strategy…
While the final third will be your “out-of-sample data” which you’ll simply use to verify the results of your strategy.
However, it is completely possible to over-optimize your plan based on the in-sample data to try and maximize your profits based solely on that data…
Which will only hurt you in the long run.
So, remember to generalize your in-sample testing and tweaking and avoid “curve fitting” your strategy.
Otherwise, you could end up with a plan that produces incredible profits on one specific historical data set…
But performs poorly in live markets.
OK, that wraps up Key 2 to a winning trading plan…
And next time, we’ll cover the third and final key.
But in the meantime, if you want a much more in-depth look at how Hawkeye helps traders understand and visualize markets in a whole new way, just click right here to watch a comprehensive training video!