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There are always a few common mistakes that are made when implementing a trading system. These range from excessive positive expectation leading to over leverage all the way to a lack of preparation and system testing. Indeed, often the actual system itself leaves a lot to be desired in terms of the logic that supports it and the market conditions it is implemented through. In this article we will look at a method of back testing and some important components to be considered in developing a trading method.
Back testing is a vital part of proving any trading system and one that should be done regularly in order to adapt trading styles to the current market conditions. As market conditions change, a trader may wish to move from a momentum trading style like a moving average system to an oscillating style based around relative strength indicators, for example. Whatever the case may be, the system needs to be tested to identify the prevailing market and decide which method will realise the most capital before real money is put into the market.
Fortunately, there are many different ways of running back tests and system validation through your HUBB software. One of the easiest ways to back test is taught in our Advanced Trading Workshop where students also receive tuition on how to improve their trade picking skills around Elliott Wave and technical analysis. This particular method of back test is demonstrated here using Integrated Investor as the primary trade selection device. To have a quick look at the philosophies behind Integrated investor and to understand how integrated analysis works, just quickly review the link: http://www.hubb.com/ia/?nav=webinar.The back testing process is simple enough; just select the “Open Precomputed Scans” from the drop down list in the “Scanners” tab (note that the same can be done for HUBB Investor and ProfitSource but with far fewer options).
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Once you have done this, just intersect the different Precomputed Scans you wish to test as part of your system. Of course, the system you want to test should be one that is based upon a logical sequence with parameters that are ‘congruent’ with one other. There would be no point looking for trades that are offering bullish and bearish signals, for example, as one will naturally cancel out the other. Equally, a mistake that is prevalent with many novice traders comes from trying to build systems around indicators that are co-linear. Simply put, this means that looking at a moving average cross over combined with a MACD (moving average convergence divergence), for example, does nothing more than look at two lagging indicators calculated from the share’s price. As such they are going to often give similar results – the price goes up and a little while later the moving averages cross and the MACD gives a bullish signal. It would make far more sense to observe the problem of share selection from different perspectives. A slightly more sophisticated trader might use share price indicators (such as moving averages) in combination with volume indicators (such as on balance volume). By increasing the number of different perspectives, there can be an increase in the level of success as multiple views uncover any previously hidden reasons not to take a position. Sophisticated traders may go even further to look at the options market and/or the fundamentals of a share in order to make high quality trading decisions. The choice of combinations within Integrated Investor is massive as illustrated by the screen shots below, although the combination used in this case is defined by the red crosses.
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The red crosses show which precomputes are being intersected – the results will therefore need to meet ALL of the chosen criteria. The following bullet points give an overview of the logic behind the selections:
- High Implied Volatility: Implied volatility is the share price volatility implied from the options market. IV insinuates that option traders are expected the share price to move (increase in volatility).
- Negative Option Volume Change: A fall in option volume is likely to occur when there is uncertainty in the options market. Fewer buyers of options could be indicative of a change in trend. This notion coincides with the turning point of a successful Elliott Wave Sell.
- Bearish Trend: Using a combination of trend strength indicators and trend direction indicators, it is important to check that the overall trend is down as the trade is a short (in sympathy with the Elliott Wave Trade)
- Bearish Trend: Using a combination of trend strength indicators and trend direction indicators, it is important to check that the overall trend is down as the trade is a short (in sympathy with the Elliott Wave Trade)
- Elliott Wave Four Sell: This final piece acts as the entry signal within a tested trading strategy including stop loss placement, entry and trailing stop placement.
In order to back test we need to change the date of the precomputed scans from today into a time in the past. At random, the 13th of August has been selected.
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The results of this action are displayed in the image below. It is possible to check what criteria have been cross referenced in the lower left hand corner (circled in red).
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For this date and with these criteria in Australia, there is only one result: Wesfarmers (WES). All that needs to be done now is to click on the chart icon within the list and investigate the trade to see if it was successful or not. An entry based upon your trading plan rules (in this instance a break of the trusted EBOT) and a consistent trailing stop strategy (such as a volatility-based trailing stop).
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Once this is complete, it is possible to scroll through more dates to see if other trading opportunities arise and test the validity of the system.
One final and ultimately important consideration which can be seen on the chart, relates to the notion that black box trading systems never work in the long run. The trading system described above looks to create a shortlist of high probability possibilities which can then be scrutinised in more detail. A good trader will always add further analysis with trusted tools, such as support and resistance and whichever indicators they are trained in the use of before pulling the trigger.
Stay Sharp
John Jeffery
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