Gaining Faith in the Model: How Backtesting Can Change a Trader's Mindset
Gaining Faith in the Model: How Backtesting Can Change a Trader's Mindset
However, from where does such self-control originate? You don't inherit it as a character flaw. I think it's fake.
No airline would ever trust a pilot with only a manual knowledge with a billion-dollar plane. Pilots are required to log countless hours in a flight simulator before they are unleashed into a real storm, where lives are really on the line. Pilots train in this virtual environment to deal with engine problems, dangerous weather, and complicated aircraft systems until the proper reactions are second nature. A trader's flight simulator is backtesting. Building the self-assurance and self-control to fly by your instruments rather than your fears in the face of market volatility is an essential and non-negotiable task.
Your "Gut Feeling" Is Actually a Trait: Debunking the Natural Pilot Myth
The most exaggerated and perilous trading myth is the one about the "natural," the trader who makes money just via his or her innate intuition and extraordinary "gut feeling." Although gut feelings can be helpful, depending on them to make important business decisions is like a pilot attempting to navigate a modern jet through a tornado without proper preparation. Nothing good will come out of that.
Over millions of years of evolution, our instincts have been fine-tuned to help us navigate a world filled with social tribes and physical dangers. They have exceptional vision, making them ideal for detecting predators in the grass or determining the reliability of an unknown person. Unfortunately, they lack the necessary skills to successfully traverse the intricate, theoretical, and outcome-based realm of financial markets.
Here, our gut tells us two deceitful lies that could ruin our chances of success:
"Hold on to that loser, it will come back." The psychological principle of loss aversion, which states that the pain of a loss is approximately twice as potent as the pleasure of an equivalent gain, is the driving force behind this. Because of our emotional bias, we tend to hold on to losing positions, letting the agony of even a little setback fester until it becomes a major catastrophe.
"Quick, sell that winner and lock in your profit!" People have a tendency to sell assets too soon, even if their value has improved. This is called the disposition effect. While it's nice to feel accomplished when we make a little profit, doing so eliminates the possibility of making the massive gains that are crucial to our success in the long run.
The remedy for these faulty impulses is a mechanized trading system. It is a detailed, non-negotiable plan for getting into, out of, and managing risk in a market. This is the brains of your plane, programmed to put logic and probability ahead of your hopes and fears so that it can make the best possible judgment in the event of an emergency. If the pilot doesn't have faith in the flight computer, it won't be able to help them in an emergency. Trust is established in the virtual environment.
How a Thorough Backtest Works Inside the Simulator
The term "backtesting" refers to the practice of using past market data to test the rules of your mechanical system. You can pilot your plane through the specters of previous market cycles, including bull markets, bear markets, and sideways grinds, without ever having to leave the ground.
A software assistant can make this procedure go more quickly, but it really shines when done by hand with great care.
Before Takeoff: Make sure the rules of your system are established clearly and unambiguously before you start. When you're ready to enter a trade, what is your exact signal? To establish your limit of exposure, where will you set your first stop loss? In order to safeguard your earnings, how will you trail your stop loss? Your position size can be determined in what ways? Subjective judgments have no place here.
Obtaining good, historical data for the market you want to trade is essential, as it outlines the historical flight path. You then go through time. As if everything were unfolding in real time, you proceed step by step, day by day, and enforce your regulations. You blindly follow all of your system's trade signals.
The Flight Log: A spreadsheet must be painstakingly filled up for each and every simulated deal. In addition to noting the start and end times of each trade, you should also record the total profit or loss, the length of the trade, and any other pertinent metrics.
This procedure lacks glitz. Doing it over and over again demands laser-like concentration. This tedious but necessary task must be completed before any thrilling outcomes can be achieved. Spending time alone in the simulator will help you become used to being in a crowded cockpit.
Embracing Unpredictability: The Real Goal of Conducting Backtests
Backtesting isn't just about checking if your system "works." It has a far more profound function. Going on this adventure will help you overcome your fear of flying by exposing you to the aircraft's real character.
It Shows How Well Your Aircraft Actually Performs: You will obtain a dataset that is statistically significant after recording hundreds of simulated trades. Here you may find the real measures of your system's performance, such as its win/loss ratio, average winning trades compared to average losing trades, and total profitability. Among its most crucial features is the ability to reveal its maximum drawdown, or the longest and most severe losing streak that your system has ever encountered throughout its history. The maximum amount of turbulent airflow that can be anticipated is indicated by this value.
It Protects You From Anxieties: The best training you can get is to safely experience your system's maximum drawdown in a simulator. This game will make you feel what it's like to lose ten, fifteen, or even twenty times in a row. Your virtual account's equity will fall precipitously as you observe. And you'll keep trading according to your rules. Something significant occurs when you come out of this virtual crash and observe your equity rebound and soar to new heights. You have been protected from mental illness. In the real market, you won't freak out when you hit a losing streak. Your system will remain in place. It will look like the turbulence you're familiar with and have successfully negotiated numerous times before.
It Establishes Unyielding Order: Evidence that is both objective and indisputable will be provided by your backtest results. If you were to break your rules, for example by keeping a loser too long or giving a winner too little time, you can observe the exact consequences. In the strongest way conceivable, this data demonstrates that your system's reasoning is superior to your emotional intuition. When the true storm comes and your heart is racing, this is what makes you disciplined enough to stick to your strategy.
Final Thoughts: Getting Your Wings
You are not born with an innate sense of self-assurance when it comes to the stock market. Being well-prepared is something you have to work for. To get it, you have to put in a lot of time studying, planning, and, most importantly, facing the specters of previous markets with your system and yourself.
The point of using a flight simulator is not to make an absolutely accurate forecast. There is never a dull moment during a storm. No matter how stormy the weather gets, you should be able to carry out your plan with the cool composure of a seasoned pilot because you will have mastered your aircraft, your system, and your own psyche. At that point, you will have won the right to fly.
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