Why Your Backtest Results May Not Give Realistic Results

Nov 28, 2022

Hello traders,

All the below are based on my preferences, I don't give any financial recommendations and I have nothing to sell you with this article.
I'm sharing content because I see a lot of traders being/becoming broke and I don't want you to be one of them.

Timeframes

A lot of models work on high timeframes on the charts.

They work visually at least and that's why many are only sharing with high timeframes charts greater than 4H.

We all built a backtest based on a moving average cross and got a shooting 95%+ win-rate when running the backtest engine for the very first time.

We all thought we were geniuses right :)

"Way too easy" we all thought

There is a caveat though...

For derivatives trading (CFDs, options, futures, ..) backtests always account for real trading fees.

Let me explain... We all heard/saw those rollover fees that we need to pay overnight.
This is basically how the brokers are forcing the overnight/over weekend traders to pay more fees.
While the explanation longs to pay for the shorts, and shorts to pay for the longs is poetic - those fees could eat out your position capital way before the price action has even moved.

Imagine a range during days/weeks.

You'll end up paying a lot of fees and might end up with a very negative position size way before anything interesting (from a trading perspective) ever happened.

I saw many trades being minus double digits percent PnL only because of fees.

Then, imagine trading contracts with an expiration date - this adds another challenge - and most of backtests don't even account for that either.

Leverage

Leverage increases disproportionally the risk compared to the opportunity.
Leverage 2 does increase the risk by 2 but the opportunity won't be multiplied by 2.

Well.... it would be in case the analysis is good in the first place. (assuming the risk/entry/exit plan is correctly calculated).
Assuming those analyses are made by experienced traders, then using leverage makes sense - otherwise I'd stay away from it.

I surely sound like a broken record with this...

But, I know what you're thinking

You calculated already how many trades and pips you need to earn 1M and you concluded it won't be possible without leverage.

This statement is true if you want to get rich quick which anyway always lead to get poor quick.

"Past performance doesn't guarantee future performance"

Probably the quote we hear the most in trading guys...
Generally in trading, what worked before has a probability to not work anymore the more time has been elapsed.

I don't mean it won't work anymore.

This only means we should be cautious when trading setups valid from a while ago on a specific market.

A way to not get that burden on our psychology is to indeed reduce the position sizing.
Until we are comfortable and not stressed anymore.

That's the sweet spot you guys have to find.

For some, it might be a few hundreds per trade, for others a few thousands.

There IS NOT a well-formulated generic universal valid answer for what's the best position sizing.

Apart of course from starting with tiny baby positions and scaling up from there

But for sure, once we get comfortable with one position size range level, we should go to the upper level direct above.
Direct above means, if we trade 100 USD position sizes, the next one could be in the 110-150 USD range. (and not 1K right off the bat...)

We wouldn't lift 100 kg after getting used to only 10 kg.
Trading isn't different than any skill requiring training and dedication
The challenge is to not change our goals midway after a few wins or a few losses.
And to stick with them for a few months at least.

Literally takes me weeks of training to add a few kg to my chest press barbell or biceps curls.
That's how much it took me also to increase the average position sizing by 10% or so.
Thus the more I increase it, the more time I need to get comfortable with it.
And it gets increasingly difficult from a psychological perspective the bigger the position size gets

Applies in a lot of areas in life, sport, career also.

It takes time!

The worst thing for new traders is getting early very lucky and rewarding trades.
That's what happened with many crypto traders in 2017 and 2021
They got too cocky and made that money too quickly and too easily.

Then, when the market turned bearish... they gave all it back because their experience/backtest/psychology/beliefs weren't ready for a market shift.

We're at a time where markets change constantly.
And perhaps that's why the patterns used by our predecessors 20 years ago aren't relevant anymore.

My father told me that trading 40 years ago was as "easy" stealing a candy from a baby.

Now it’s a lot more complicated due to the noise, trading bots, etc..

Often orders aren't filled

In paper trading or with a backtest, when a Take Profit is hit... well we make profit and that's cool.
But those LIVE trading know that sometimes... the limit orders aren't filled and no one can give us a logical explanation why the F... they weren't filled.

Even though the charts clearly show we should have been filled...

Your broker will say slippage.
Your guru will say "I got a nice 1000% profit - Hope you all exited when I told you so"

You will say "But my backtest claimed that an order should always be filled..."

I'm saying blaming the casino isn't useful and won't bring you anywhere

And that's why trades need to be managed because we're playing against the house (exchange) & competition (i.e. SMART-MONEY - understand bankers/funds with real advanced financial education) that want us liquidated.


I'll keep bringing a few articles like this every week because it helps me clarifying my thoughts AND giving back to the community makes me feel good about myself somehow :)
I want to teach you guys every aspects of what makes a great trader and how to get there.
This is the most challenging and the most rewarding job at the same time

Thank you for reading
Dave