How to Validate A Trading Strategy

Very few people will watch a Wimbledon tennis match and then go out and play themselves, expecting to be as good as the players they watched.

However, when it comes to the stock market, some people expect to be profitable and consistent right away.

My new service will shave years off the learning curve, but there is no substitute for experience.  

You see, before you can start serving up aces, you want to be confident that your strategy works and be comfortable trading it.  

As traders, we’re always looking for new ways that can improve our performance.

But before we actually start putting capital to work on a new strategy… we need to validate it first.

In other words, the strategy needs to show proof of concept before we put our full position size on those ideas.

Now, you’re probably wondering, How can I validate my strategy and see whether it actually works?

Well, there are a few ways to validate a strategy or idea, but the main techniques are:

  • Backtesting
  • Paper trading
  • Trading small size

Backtesting

With backtesting, you’re not putting any real money on the line, and many traders out ther actually use this approach to test their strategies.

Basically, you’re looking at historical data, like price action and charts, and seeing whether your strategy would have worked given a specific set of rules. Now, backtesting gives us an array of statistics like the win rate and profitability.

For example, let’s say you’re testing a technical analysis strategy.

Well, you can look through charts in the past and see whether your strategy would work. Let’s say you wanted to test a chart pattern out.

You can use something like stockcharts.com, or any charting software really. For example, let’s take a look at a reversal pattern.

For example, check out the chart in Ocean Power Technologies (OPTT) above. Let’s say you want to test when there’s a big up move after a stock has found support… you want to buy shares.

Well, with OPTT, let’s say you picked up shares at $2.01 (a break above the blue line). Well, you would write down your entry price, your stop-loss area, and target price… along with your set of rules, like taking profits if you’re up 10 – 20%.

Well, thereafter, you would just update the chart to see how the trade would’ve turned out.

With this specific setup, let’s say you want to take off half around $2.20 and the rest just before $2.40, let’s say $2.35.

Well, you would’ve taken profits at $2.20 and $2.35, right at the green horizontal lines. That said, you would consider this a win and calculate the average percentage return and write down how the trade turned out.

Now, with backtests, you would use this same approach and do it for dozens of times… and assess your performance after. If the strategy is profitable, then you might consider putting some real money behind the strategy.

Backtesting and journaling those trades will actually help you put together a better game plan. You see, when you review those trades… you’ll actually see a pattern and figure where the best entry zones are. Not only that, it will let you know which market conditions the strategy works in.

For example, let’s say a strategy isn’t working in a bull market… well, you could go back and look for a bear market and see if that works… or you could look for choppy trading conditions and test the strategy for that period.

Remember, when you’re testing a strategy, always trade those ideas small in relation to your account size. Another thing to be mindful of is that there may be some bias when you’re backtesting… but if you’re afraid of having hindsight bias, there’s another approach you can use.

Paper trading is another great technique to validate your ideas.

 

Paper Trading

 

Now, most brokerage platforms allow you to paper trade. In other words, you’re not using real money to trade… you’re using “fake” or “paper” money to test out your ideas.

Paper trading would be considered a form of forward testing, instead of backtesting. Basically, you’re using live data and buying and selling based on your ruleset.

It’s basically simulated trading.

Since paper trading is simulated… it’s easy to just trade for fun and treat it like a game.

However, that’s the wrong approach to have.

With paper trading, you want to treat it as close to real-life trading situations as possible. What that means is trading with an account size that’s the same as what you would be using in real life… as well as trading the same position size you would be in real life.

You would write down your plan, your entries, stop-loss area, and targets, as well as your thesis… and at the end of the trade you would write down whether the trade worked, how many shares you would’ve traded, and whether you stuck to your rules and treated it like a real trading situation.

Once you have dozens of paper trades in the books, you would review and assess whether your strategy worked. In other words, if the strategy was profitable and had more wins than losses… then you might want to put some money behind the trade.

Now, some traders actually forgo paper trading and backtesting… which is okay if you know how to take risks properly and can afford to lose a little bit of money, in relation to your account size.

However, if you’re a beginner, paper trading and backtesting could help to prevent losses as you’re learning the ropes.

Testing Your Strategy With Small Size

Some traders actually like to put real-money behind their trades as their testing their strategies. You see, when you put real money on the line… there will be emotions… and no “bias” like there is with backtesting.

Now, if you’re testing your strategy with real money… make sure you can afford to take the losses. That means keeping your position sizing small. For example, let’s say you’re comfortable trading 500 shares with your money-making ideas.

Well, when you’re testing strategies with real money… maybe you want to trade with 25 or 50 shares to test. That way, you won’t be risking a whole lot… and if the strategy doesn’t work, you won’t damage your account.

That said, there are a number of ways to validate a trading strategy… but make sure the one you pick suits you. Maybe you’re not comfortable putting real money on your new ideas just yet… then you might look to backtest or paper trade.

Final Thoughts

Developing a new strategy isn’t easy. After all, when I discovered my three patterns for trading small-cap stocks I thought that’s all I would ever need. However, markets evolve, and as traders we must find ways to keep winning.

That said, I’m happy to announce that after 7 years, I have come up with a strategy that might put my small cap trading to shame. I’m not joking.

I know I’m up over $320K this year from trading small-caps, but my Weekly Windfalls strategy has proven to be more accurate, offer more opportunities, greater consistency, and profit potential.

Do yourself a favor, and join me this Thursday, July 11, at 8:30 PM ET.  As I reveal Weekly Windfalls, my newest strategy, and soon to be my most profitable.  

Leave a Reply