- 1998: Volume 7, No. 2 How Good Is Your Data? Backtest It!

How your trading system will perform in the future is often predicted byhow it performed in the past. Consequently, backtesting a trading methodology will be one of the first steps toward implementing your mechanical trading system.

Today, many resources are available to assist in the backtesting process. In fact, online resources are quickly becoming the mainstay of the system developer. Resources currently available range from free historical data to charts to numerous web sites devoted to the system trader.

Commercial Systems Testing

As you move through the process of either testing your own system or a purchased system, be prepared to do the backtesting yourself.

While there are groups in existence that claim to offer the consumer an unbiased test comparison of various trading methodologies, the backtesting firms in the commodities field are not reliable for several key reasons:

• These firms do not use portfolio or money management in the system testing process.
• Fixed baskets of commodities are used for testing purposes.
• Tested systems involve only entry/exit indicators on a single contract basis.

A system cannot be adequately tested until money management rules are defined. Common single contract measures of trading system performance such as win/loss ratio, percent winning trades, etc., are of little value to analysis. Often the best trading approach, when tested on a single contract basis, will not be the best approach when money management is incorporated.

The following list of money and portfolio management concerns must be accounted for within the backtesting process:

• How much capital do you place on each trade?
• When should you take a loss to avoid larger losses?
• If you begin a losing streak, do you trade the same? What formula do you use?
• How should you prepare if trading both long and short positions?
• Is trading affected by commodities that move at different times?
• How is correlation handled in a practical trading sense?
• Does a portfolio of long and short allow one to trade more positions?
• How is your trading adjusted with accumulated new profits?
• How are stops handled when volatility is a concern?
• Is there a method to limit entry risk with options?
• How does one prepare for unforeseen large scale trends?
• Psychologically, money and gains must be viewed as a means of keeping "score".

These points are often overlooked by new traders. A tendency to focus on the next great entry/exit indicator often leaves money and portfolio management underdeveloped. But in the long run, your system's success will depend on how accurately you test and trade with proper money and portfolio management.

Software for BackTesting

TradeStation has become a central component of many investors' and traders' trading strategy. The software has grown over the years from its old "System Writer" package to its current package of real-time feeds and indicators by the hundreds. TradeStation is a fine product and allows for ease of use in systems back testing, but it is not a prerequisite for successful backtesting.

Software and various programming languages developed many years ago often do fine for today's trader. In fact, the flexibility in these programming languages and scripting tools can still outshine the newer software packages. Old standards like System Writer, Excalibur, BASIC, FORTRAN and Lotus 1-2-3 are often unknown to the new trader.

Do not focus on the bells and whistles found in newer software packages, but rather on the functionality you will need to backtest and implement your mechanical trading approach. Ultimately, the computing platform and software you run are tools in the automation process, not trading methods themselves.

Charts for BackTesting

Barchart.com (www.barchart.com) is a fine location for online charts. This site is one of the most comprehensive sources of detailed charts on the internet. Much of their content is absolutely free and easily accessible.

Source: Barchart.com

Where Can I Find FREE Data for Backtesting?

FutureSource's web site (www.futuresource.com) is a great location for nearly real-time free data. If you are a long-term trader this site is perfect for research and trading. FutureSource's web site is easy to navigate and very responsive.

Another helpful online location for free historical data is the TurtleTrader site (www.turtletrader.com). There are eight megabytes of free data at TurtleTrader encompassing many major contracts on U.S. futures exchanges dating back to the 1970s. All daily data is in ASCII/text format, easily imported into most spreadsheets or investing products.

Summary

If you are not online using the many free data resources available, you are not saving money! Backtesting a successful trading methodology will require data and with the internet providing numerous resources, there is no better time to go online. I believe the internet will quickly become a key tool in your backtesting success.

Gerald Mullins is director of marketing for TurtleTrader.com and can be reached at info@turtletrader.com or 1.888.663.6688.