In my last post, I went over how to manually test your trading strategy. Before you put a lot of your real money at risk trading a strategy, you need to test it to gain confidence. As I state in the post, you start with back testing on a demo account and finish with forward testing with real money (although the amount you risk is a lot less than you plan to trade). The goal of the exercise it to find a trading system that is both profitable and that you can trade in the live markets in real time.
Don’t fall into the forward test, live trading trap!
In my experience of testing literally hundreds of trading systems over the years I’ve come across a trap, or phenomena, that I want you to look out for. This trap happens when you switch from back testing to forward testing and can force you to abandon a good trading strategy prematurely. And if you spent the time to build a solid trading strategy, with everything that entails, the last thing you want to do is abandon it unnecessarily.
The big difference between back testing and forward testing is time. You can back test a trading strategy very quickly. You can go over months, or even years, of data in a very short time and see what the system “would have done”.
However, when you switch to forward testing, things slow down considerably. You can only trade one day at a time and take the trades that present themselves. If you are trading a system that requires you to monitor the markets for long hours a day, the time it takes to trade can seem eternal.
The Forward Test, Live Trading Trap
You back test your strategy and are completely happy with the results. But when you forward test your strategy, you become very frustrated and start wondering if trading is worth it. (This frustration can lead to abandoning the trading system all together, even if it is profitable).
You are back testing a trading system by scrolling back in the charts and documenting the trades and their outcome. There are winning trades and there are losing trades. There are losing streaks to contend with. But it all goes by so quickly, the emotional stress brought on by the losses only lasts for a very short time. You just keep scrolling forward and you start seeing those winning trades that makes everything feel fine.
You start tallying up your monthly gains both in terms of percentages and dollars. Even if the percentages are good from month one, the money in the beginning is not all that much. (If you had a $1000 account and a profitable 25% month, you would have only earned $250). But since you can back test many months at a time, you soon start to see how the money adds up (especially with compounding), and start to feel really good about the system.
The Transition To Forward Testing Your Trading Strategy
What happens when you start forward testing the system and everything slows down?
When you start testing the system in real time, it starts to feel like you are walking in quicksand. Some days you might not have any trades at all. Some days might end up as winners and some as losers. But those losing days really hurt and it could be days before you make up the losses. And each day seems like an eternity.
Even if you can stick to your trading rules and get good results, the money in the beginning does not seem worth it. Remember, even if you had a great 25% month with $1000 starting balance, you only made $250. That amount of money just does not seem like a lot, especially if you’ve had to sit in front of the charts for hours each day.
The feelings of stress after losses and dealing with low amounts of money being made is quickly fixed when you are back testing. You just keep going and if you have a good system, things start to look very impressive. The longer you back test, the more likely you are to reach profit numbers that could be life changing.
However, when forward testing, the stress of loss is magnified and lasts for longer periods of time. At the end of the trading, the dollar amount earned might not seem all that impressive, even if the percentage for the month is good. It can become very hard to stay motivated and keep trading in a disciplined fashion.
The tendency will be to abandon this trading strategy and look for something “better”. Basically, you’ll be looking for something that has less losses and makes more money, faster. And thus, the search for the Holy Grail trading system begins. And if you are not careful, you’ll get trapped into the cycle of back testing systems and abandoning them when you start to trade live. In the end, you will never become a successful trader because you never trade any system long enough to reach your goals.
I bring this to your attention because I want to keep you from falling into this trap. If you find a trading system that is profitable, you need to trade it long term. While this can be challenging, you must find a way to stick to the plan, even if it seems boring or not worth your time in the beginning. In my opinion, trading should be boring if you are going to succeed.
If you have fallen into this trap when you start to forward trade a system, please leave a comment with your experiences. It might help others from making the same mistakes.