14 min read

How to Know If Your Trading Strategy Has a Real Edge

Published by Rank My Prop Editorial

Reviewed ByZeeshan

Why Most Traders Never Test Their Trading Strategy Properly

One of the most common mistakes made by traders is that they consider their trading strategy to be a profitable one because they win several times. Traders can have five to ten consecutive profitable trades and feel like they have developed a winning trading strategy. Nevertheless, financial market is not predictable, and therefore, such results happen due to the favorable market environment and not due to the strategy itself. Many traders participate in contests organized by proprietary firms without collecting enough information to understand whether their strategy is profitable or not. In most cases, it leads to disappointment as the strategy becomes unprofitable under another market environment. Experienced traders know that any strategy should be tested objectively before risking any money. Contrary to many traders who follow their intuition and social network advice regarding their strategy, professional traders collect statistical data on the basis of a significant number of trades.

Backtesting and its Significance in Live Trading

Backtesting, however, becomes the most beneficial tool for traders since it allows traders to check their strategy by using historical market data. Rather than guessing whether the strategy is working or not, traders can find out the performance of their trading strategies through hundreds of trades carried out in the past. It is important to remember that a successful backtest should include many different kinds of market conditions, including trending, ranging, and volatile markets. In addition, traders should monitor several useful statistics, such as the win rate, average risk/reward ratio, maximum drawdown, and overall profitability of the strategy. All this information will help traders to conclude that their trading strategy has positive expectancy. Nevertheless, traders should understand that backtesting will not suffice. Even though there is no guarantee about future performance on the basis of the historical performance of the strategy, it is a good start.

The Reasons Why Forward Testing is Equally Important

After the traders have tested the strategy via back testing, the next logical step would be to conduct the forward testing of the strategy using the demo account. Through this, traders will be able to determine whether the strategy will work in the current market environment, and will be given an opportunity to test their own trading strategies. Unlike back testing, forward testing will involve more real-time decision making on the part of the traders, thus helping traders to uncover any weaknesses that they might have when it comes to their strategy execution and psychological weaknesses. Traders at this point should still keep proper statistical records to compare them to the results from the historical record keeping.

The Key Trading Performance Indicators for All Investors

The profitability/loss is probably the most obvious metric that traders consider in their analysis of the strategy performance. However, there are many other metrics considered by professional traders apart from the win rate. While the latter provides useful information, it is always important to look at it together with the risk-to-reward ratio. The maximum drawdown will indicate the potential losses one may incur in case of adverse market conditions, while the expectancy will demonstrate the average gains or losses per trade. Other useful metrics that should be considered are the average time spent on each trade and average monthly return. Traders gain a whole new outlook on their strategies by evaluating these metrics. Internal Linking Opportunity: It is recommended that traders find out Why Risk-to-Reward Ratio Is More Important than Win Rate and How to Use a Trading Journal for Prop Firm Success.

Strategic Planning Mistakes to Avoid

Many traders unintentionally invalidate their test results due to errors in their approach to backtesting. For instance, some traders will alter their rules during the course of backtesting, rendering the data collected irrelevant. Other traders end their testing period after a couple of unsuccessful tests, assuming the strategy has become irrelevant. An additional error is neglecting the impact of commissions, spreads, and slippage on the performance of the strategy. Emotions become an issue when traders focus only on successful trades and ignore the losses. Professional traders prevent such errors from occurring by maintaining consistent backtest procedures and recording every single trade objectively. The purpose of backtesting is not to prove the perfection of the strategy. The purpose of backtesting is gaining knowledge about the strategy.

The reason why most traders unconsciously negate their testing outcomes is because of making the same errors time and again. For instance, there are some traders who change the tra

No confidence is more powerful than confidence based on facts, rather than the optimism. The traders who have correctly validated their trading system understand what expectations they can make about the upcoming tournament because they know the results of their work for dozens of trades. Thus, the traders have a certain level of confidence, which allows them to relax during the losses in several trading sessions because they know that it is just a statistic and nothing else. Rather than adapting the trading system after each week of difficult trading, they base their actions on the facts they got from the validation process. At prop firms, there should be no room left for assumptions and hopes when talking about confidence.