Back tests are views into historical price action, they are not crystal balls that show us how profitable a system will be in the future. The best use of backtesting is as a filter to test your ideas and see if they would have worked out in the past before you try to trade them in the future. If your trading ideas lost money in the past the odds are they will lose money in the future. If a back test made money in the past the odds are that the principles of entries are sound and that they capture price moves so they can be used in the future. Profitable back test parameters are not the Holy Grail they are simply systems that worked in the past with a potential to work in the future if traded methodically.
While finding successful back tested systems is a great start on your way to a profitable trading system be aware that these are 12 things that a back test will not show you:
- How it feels when real money is at risk in a systematic way.
- How losses feel during a losing streak.
- How losing money feels during volatility and false signals.
- The perseverance needed to stick to a good system long term when it goes into a draw down.
- How hard it is to keep the faith if you start trading a system and it immediately goes into a draw down.
- The patience to do nothing except wait for a signal.
- The temptation to optimize your mechanical system in real time trying to adapt to the current price action.
- The cost of taxes on your capital gains. There is an edge in trading inside a tax deferred account.
- The cost of commissions when you have many signals to execute in a short amount of time.
- The liquidity of a market.
- The ability to follow entry and exit signals regardless of how you feel, think, or want to predict what will happen next.
- Whether it will really work in the future. These are back tests on historical data not front tests on the future. The principles of the systems are sound but the nature of future trends determine the success or failure of these systems not anything the trader can control or predict.
If you are not able to follow your back tested system long term with discipline nothing really matters, it will not work.