Backtesting, Forward Testing, and Constant Monitoring
Plus a short story
After you backtest a system or a trading concept, you should also forward test it with live data. You should trade it for a few days in a paper-trading account before committing real money to it. Doing so will also help you validate your backtesting results, making sure the strategy is ready for real trading.
Also, by live testing it, you will be able to watch how a market reacts to a particular trading setup in real time, and that is one of the most valuable trading lessons you can take. It will teach you a lot more than just backtesting it would, because you will start having new ideas to refine the system.
Real Trading Example: After something that looks really good comes out of a backtest, I like to trade it with a fifth of my normal size for a week or two. (I am talking about very short-term systems.) This lets me test the waters, gain confidence, and see if I may have missed something important—all habits I highly recommend.
Homework: Pick one market and watch it every day for a month. Get to know that market inside out. Gain a deep understanding of how it moves; watch it throughout the day, and get in sync with its rhythm, its range, and how it reacts to new intraday lows and highs. By watching only one market and not listening to headline news, you will slowly but surely become an expert in price patterns—the only thing that really pays in trading. Try it out.
The Seismic Trade
The day was progressing calmly on Wall Street when suddenly the ticker flashed, "Major Earthquake in Northern China: Qinghai with Damaged Infrastructure." Vivian Steele leapt like an Olympic gymnast and fired off an order on the keyboard with lightning speed.
Maxwell Dither, in his usual eloquence, commented, "That area is very prone to seismic activity; it's where India collides with the rest of Asia." John Spinner didn't hear Maxwell's geology lesson, his eyes glued to Viviane.
"Carter, did you notice that as soon as the headline appeared on the monitors, Vi immediately placed an order? What did she do? Ask her!" John urged.
"There you go, John! So outgoing about almost everything and so shy with Miss Steele! Why, I wonder..."Carter replied.
"Come on! She definitely did something smart, but what?" John persisted.
Maxwell Dither looked at the quotes and exclaimed in surprise, "ArcadiaX Gaming (DIAX) is down 27%! Strange...could it be a glitch?"
Vivian quickly explained, "ArcadiaX produces 90% of its consoles around Qinghai. With the destruction that an earthquake like this causes to factories and road infrastructure, they won’t have consoles available in stores for Christmas. Production was already slightly delayed and now the holiday season is irretrievably lost."
"Miss Steele, how do you know that ArcadiaX Gaming produces 90% of its consoles in Qinghai?!" Carter asked, amazed.
"I read it in the annual report. All the information is there."
"And the order you placed was related to that?" Carter continued.
"Yes, I was quick...one of the first to react or maybe the first. I managed to short sell 50,000 shares before the sell-off. I’ve got a good open profit on this position, capturing almost the entire sell-off. My week is made," Vivian responded confidently.
John whispered, "The week? I wish that were my entire year..."
Mortimer Sagecroft, who had listened with interest to the entire interaction, commented,“Well, I admire Maxwell’s knowledge and broad cultural understanding. He knew (…)
(Excerpt from "Seismic Trade", Vivian Steele: The Queen of Wall Street)
