The Truth About ‘Backtesting’ To Find Trading Edge - Research Article #51
Backtesting doesn't work for what most traders think.
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The most frequently asked question I get in my inbox is:
“How do I know my backtest will work?.”
That is a fair question, but misguided.
If you want your trading business to be profitable, that is not the question you should be asking.
I’ve never shared publicly what I am about to share…
Not because it is a secret, but because I don’t want newer traders to get the wrong idea about building a systematic trading business.
At the end of the day, I do think that backtesting is important to validate your ideas. And it’s REALLY important for proper capital allocation and risk management.
But it’s not important for finding edge.
When I deployed the model that generated the LIVE performance below…
… The truth is, I didn’t even have a proper backtest.
Yet, I probably have outperformed the vast majority of so called “traders” for the past 3-4 years.
At the time, when I was just getting into crypto, it was late 2021, and everything was going crazy.
I wanted exposure, and didn’t have time for proper backtesting.
So I did what every trader that knows his edge does…
I tested in production.
I knew what I had should work, because I based it off solid principles.
What are those principles?
Let’s get into it!
A Barber’s Edge in the Market
Last week, I was at the barber, and while sitting at the chair, getting my hair cut, my mind starts wondering:
“I know why I get paid for trading, but why do I pay the barber?”
As simple as it may sound, I truly believe that this question lays the foundation for making money in any market.
As I was sitting there, I wanted to apply the same framework I use for finding edge in markets, but to the barber’s business.
What kind of service he provides?
What capacity is there for his service?
What risks is he taking?
The service is quite clear.
He is a skilled barber, otherwise I wouldn’t be there. He told me stories of how during school he spent his summers learning to cut his friend’s and family’s hair to get better. He had a true passion for the skill, and that made him great.
Also he knows the value of his skills and he charges a premium for his time. There’s cheaper barbers that don’t hold the same degree of skill that he does.
He is also in a relatively small town. Everyone needs to cut hair, and he is one of the best in town. This makes his services highly attractive.
I need to book 1-week in advance to cut hair with him these days, because he is always fully booked.
In terms of risks, he carries a lot of them. He has to pay income taxes, pay his workers, pay rent, pay utility bills, equipment, etc.
All of these are variables in an equation that amounts to his revenue.
Seems pretty straightforward, but so many people fail to apply this simple idea to their trading business.
They think that by opening up a fancy backtesting software and getting rules together to form a beautiful equity curve is the way.
No.
That’s why so many of them fail and will continue to do so.
Backtesting even though important, is filled with problems that most people are not even aware of.
It’s just a tool like any other…
Index
Introduction
Index
Backtesting: A Bad Solution to Finding Edge
Providing a Useful Service
Carrying Risk
Being Paid for Risk
A Practical Example to Finding Edge