Monday, March 14, 2016

The Fallacy of Backtesting and Adapting to Current Market Conditions

I recently engaged in an interesting chat with a novice trader this weekend. It got me thinking about the fallacy of backtesting and why I don't rely on past statistics. 

You heard me correctly. My take on backtesting is controversial and puts me in the minority. Some have called me an idiot for this view and I don't mind at all. The majority is often wrong, and I've made a career out of going against the grain. 

Here's the conversation that illustrates my point.

Paul, how are you doing trading breakout-pullbacks?

I haven't traded any this year.

Why not? A few years ago you made a killing off that setup.

That was a few years ago.

Yeah, but I backtested the past 10 years and they have a 58 percent win rate and average gain over 7 percent on winners.

Nice stats but they don't apply to this market.

Stats don't lie Paul.

Have you made any money this year trading breakout-pullbacks?


The take away from this chat is that you need to understand the current market you are trading. Backtesting can give you a general idea of how reliable a setup is, but there is much more to trading a setup. 

You can not test for every variable and different market reacts differently to specific setups. A successful swing trader must understand the current market and adapt accordingly.

Forget about backtesting, understand the current market conditions, and trade right setup for the right market.

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Raven said...

Agree. To me this goes in the same discussion/belief about reading stock trading books. Books along with backtesting set up a false sense of security that they will greatly improve your odds of winning. Read the best books (perhaps less than 10% out there) and/or trading websites that fit your personality and review your trades are a better subscription for success (beating the market).
Nice post.

Ariel Silahian said...

You are wrong. The Backtesting is to understand how your strategy behaves in "any" market condition, not only on current.
What's even worst is that you recommend to avoid backtesting!!
So, you are trading based on what?

michelle said...

I think the point is that you can use backtesting to determine which setups work best in which markets generally, but then you should Apply that knowledge to any future analysis or trading you do. More importantly, to improve your trading, focus on understanding the market cycles. Backtesting is just one method of analysis and it gives you limited information. If you want to backtest continually, then test specific setups In the market they are most relevant to.
Metaphorically, after your first year of buying clothes, you backtest to see how well bikini's work in each of the 4 seasons: Generally they work in summer, not so much in winter.. Why would you then focus on testing how bikini's work throughout the year, every year or over the last 10 years... You can backtest to figure out how well You've rocked ur bikini over the summers in past years but it's more fruitful to focus on understanding the Season, its intricacies and context to adjust your strategy for dressing appropriately.
I'm such a girl, lol, but you should get the point Paul's making a bit more hopefully.