Developing A Trading Strategy Part 1: The Baseline Test

Do you know what goes into developing a successful trading strategy? Probably not. Most traders are like me at the beginning of my trading career in thinking that it’s as simple as browsing the internet, finding a heavily viewed video and just copying them. Sound familiar? In fact, I would argue that many of you wouldn’t just copy the YouTuber, but you’d then change something around so that it would feel like yours and feed that hungry ego of yours.

In hindsight it’s a ridiculous assumption that it would be that easy, seeing how over 90% of traders fail, but of course, at that time we never consider it with all of the get rich quick nonsense that’s being ingrained in our cerebrum. The truth is developing a strategy takes time & the majority of that time is spent finding out what doesn’t work. I think it was Thomas Edison that once again I have not failed. I just found 10,000 ways that didn’t work when inventing the lightbulb.

Each December I dedicate a few weeks to my continued education as a trader and this year I wanted to fill a void in my trading business by finding a strategy that I can execute on the daily charts. I started with a pretty clear idea of what I wanted to do, but as I tested and failed and tested and failed and tested and failed, I ended up in a completely different place. By the way, this is normal.

What I love about MANUAL testing is that it’s a constant observation of the market. So while going through 10 years of data about 10 different times thus far this winter, I’ve been able to make numerous observations that have allowed me to adjust what I thought I wanted to do, into what I’m currently doing.

When testing an idea I start off with a very general hypothesis, and I run it through a test which I call a baseline test. At this point I don’t care about optimization, I simply want to see if the idea works. If it does work then I want to ensure that it works in a way that fits what I’m looking for. For example, earlier in the month I tested an idea that worked great…However, the win percentage was in the 30s. Now there’s nothing wrong with having a 30% win percentage (as many true trend traders have had in the past), but for me personally, that’s not a position that I’m looking to be in because I know that it would lead to some trading psychology issues. Although I couldn’t find a way to make that idea work to my liking I did learn a lot from it, which allowed me to test another idea.

Above is the equity curve from the initial baseline test of the latest idea that I’ve tested. Now many of your eyes were probably drawn to the far right which makes it look exciting. Mine, however, are stuck right in the middle at the massive drawdown that occurred before the extension. Typically, the goal of a newer trader is to make as much profit as possible, while the goal of an experienced trader is to conserve as much capital as possible. It took me some time to learn that but trust me, it’s one of the most valuable mental shifts that you can make. Making money is easy, refraining from giving it back is the hard part. (RETWEET THAT LINE WHEN YOU SHARE THIS ARTICLE)

Despite the massive drawdown the idea does have promise and understanding the type of market condition that we were in during that drawdown allows me to understand what type of filters and qualifiers can be tested to hopefully get rid of a handful of losers without taking too many winners with it.

More importantly, this curve is a perfect example of why we want to conduct our backtesting over a long period of time. Market conditions change and certain strategies work better during specific conditions. If we only test during the conditions that are in our favor, we won’t know the full story and will put ourselves at risk of blowing everything when they change out of our favor. Also, vice versa, sometimes we may give up on a system too early because we’ve only tested it during a bad period.

I’m excited to start the next round of testing on this strategy and I hope that you guys hang with me for the ride. I honestly have no clue if something will become of this or not, but I did something very similar to this last year with the traders at Tier One and they enjoyed seeing the process more than anything else. I won’t go into as much detail as I did with them in the video versions but I hope that there is something to gain from this year’s edition as well.

To view Part 1 of the presentation that I did on this subject please check out the video below. (Remember to SUBSCRIBE if you’re new, that way you don’t miss the next installment which will be coming soon!)

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