Throughout the years I’ve been trading and writing I've often written about mind set—having the right frame of mind for your trading so you become a winner.
I've stated that it is our job to trade "futures," not "histories."
The future is the next bar on your chart. You can't possibly know how it will develop, how fast prices will move, or where it will end up. Since none of us know where the very next tick will be, it's impossible to know where the tick after that will be, or the tick after that, etc. All we know at any one time is what we're seeing. Interestingly, what we're seeing may not be true.
If we are daytrading, we are not sure that what we're seeing is a bad tick, especially if it is not too far astray from the price action.
The daily bar chart doesn't always tell the truth, either. The open may not be where the first trade took place. The close is merely a consensus, and may be quite a bit distant from where the last trade took place. The high may not have been the high, and the low may not have been the low. If you don't believe that, then I challenge you to pick up any newspaper and take a look at some of the back months.
For example if the exchange has reported that a back month they opened at 9755, with a high of 9802, a low of 9760, and a close of 9784. Does that make any sense? How can the low be higher than the open? How can the close be higher than the high? Yet that's the kind of garbage we have to put up with in this business.
Now you know the problem with back testing. Back testing and simulated testing are based on nothing but lies. That's why they don't work when you actually put them to the test with real data.
In fact, there are many reasons why back testing and simulation won't work, and I may as well dump them in your lap right here.
Because you don't really know where the high or low were, or if the market ever really traded there, you don't know if your simulated stop was taken out or not.
If you say you have a system in which if you get three up days followed by a down day, the market will be up twelve days from now 82% of the time, then your whole statistical universe may have been based on what is not true.
Have you ever watched cocoa from the open to the close? You can clearly see it trading at the open, but by the time the market closes, the open will at times be placed opposite the close. That might be fifty or more points away from where you saw it open and trade, and also as born out by a report of time and sales.
The way they report cocoa prices is going to give a fit to a lot of candlestick traders. Why? Because they are going to see far too many "doji's" (open=close), more than are really there. Cocoa is not the only culprit, but historically, it is certainly one of the worst
When you see a completed bar on a chart, you have no idea which way prices moved first. You don't know if they moved down first or up first. You don't know whether or not prices opened and then moved to the high, went down to the low, and then traded in the lower half of the price range until the close, at which time prices soared up to the high and closed there. You have no idea of the overlap. I've seen prices trade from one extreme to the other more than once at each extreme.
In any of those instances, your protective stop could have been taken out intraday.
You know nothing of the market volatility on any given day, once you see a completed price bar. Were prices ticking their normal, exchange minimum tick, or were they ticking two or three times the minimum every time prices ticked?
Even if you purchased tick data for your simulation, showing every single tick the market made, you don't know what the volatility was. For instance, you don't know if the S&P was ticking five minimum fluctuations per tick or twenty-five minimum fluctuations per tick, and if it was doing it quickly or slowly. You don't know and you can't know, and anyone who tells you their simulated system works, based on such phony baloney, is a liar.
Not knowing how fast the market was means you can't really know what the slippage might have been. The faster the market, the greater the slippage. You can sit there and say that you would have gotten in at a certain price or that you would have exited at a certain price, but if you don't know the market volatility, and how fast the market was, you do not know enough to say that you would have done such and such. Not knowing how fast the market was, you have no way of knowing how much slippage there would have been on your entry or your exit. Without knowledge of slippage, you can't possibly know the risk.
That is also true of volatility. Volatility is made up of range of movement, speed, and tick size. If you don't know the extent of slippage, you will not know the extent of the risk you would have encountered.
As if that's not bad enough, you also don't know how thin the market was at the time you would have traded it. If you are position trading, you can't go by the reported daily volume (which is always too late to do you any good), because there is no way to know what the volume was at the time your price would have been hit. So here again you have no idea of what slippage you might have encountered, and once more you would not have known the risk.
If you want to spend your money on trading systems based upon the unknown, then you must assume the risk of doing so. Since this is a business of assuming risk, you are entitled to insure prices in any market that you care to.
Insurance companies spend a lot of money to make sure that the risks they take are actuarially sound. That is the equivalent of finding good, well-formed, liquid markets to trade in. But any market can become totally chaotic. Markets can become extremely fast, and they can become quite volatile. So even if your system was back-tested in a liquid market, when that market becomes fast and/or volatile, your back-tested, simulated system will not be able to cope with it and you will lose. It's like going out to write life insurance on a battle front.
If your back-tested, simulated system does factor in some room for fast and/or volatile markets, then, when you will be trading in slow, non-volatile markets with the built in factor, you will be utilizing a system that is totally inappropriate for the slow, non-volatile market you are in. The best you can hope for is an "optimized" system. How can you possibly expect to compete with traders who are acting and reacting to the reality that is at hand at the time?
Extensive back-testing is for historians, not traders. It is the wrong view of the markets. Your trading must be forward looking without being ridiculous about seeing into the future.
If you don't know where the next tick is, how can you possibly know where the next market turning point will be? Can you see into the future?
Maybe you like to trade astrologically. Those people are always trying to peer into the future.
In the auto business they have a saying, "There's an ass for every seat." Likewise, there's a fool for every fortuneteller who claims he can see into the future.
I guess you can always go out to your local coven and hire a witch to tell you what beans will do tomorrow. She may even be right from time to time.
You could always do as one charlatan did and run the biorhythm for each market based on the day it first started to trade. Or, you can cast the markets horoscope based on the same date. With the biorhythm, you'll know what time of day the market should be on its highs, and what time of day it will be on its lows.
You'll know which day the market will be ecstatic and reach a new high, and which day it will be down in the dumps and make a new low. However, you'll find that from time to time the market will reach new lows on the day it was supposed to reach new highs. Well, that's easy enough to explain. You can tell everyone "We've had an inversion. Until the market inverts again, the lows will be the highs, and the highs will be the lows!"
I've stated that it is our job to trade "futures," not "histories."
The future is the next bar on your chart. You can't possibly know how it will develop, how fast prices will move, or where it will end up. Since none of us know where the very next tick will be, it's impossible to know where the tick after that will be, or the tick after that, etc. All we know at any one time is what we're seeing. Interestingly, what we're seeing may not be true.
If we are daytrading, we are not sure that what we're seeing is a bad tick, especially if it is not too far astray from the price action.
The daily bar chart doesn't always tell the truth, either. The open may not be where the first trade took place. The close is merely a consensus, and may be quite a bit distant from where the last trade took place. The high may not have been the high, and the low may not have been the low. If you don't believe that, then I challenge you to pick up any newspaper and take a look at some of the back months.
For example if the exchange has reported that a back month they opened at 9755, with a high of 9802, a low of 9760, and a close of 9784. Does that make any sense? How can the low be higher than the open? How can the close be higher than the high? Yet that's the kind of garbage we have to put up with in this business.
Now you know the problem with back testing. Back testing and simulated testing are based on nothing but lies. That's why they don't work when you actually put them to the test with real data.
In fact, there are many reasons why back testing and simulation won't work, and I may as well dump them in your lap right here.
Because you don't really know where the high or low were, or if the market ever really traded there, you don't know if your simulated stop was taken out or not.
If you say you have a system in which if you get three up days followed by a down day, the market will be up twelve days from now 82% of the time, then your whole statistical universe may have been based on what is not true.
Have you ever watched cocoa from the open to the close? You can clearly see it trading at the open, but by the time the market closes, the open will at times be placed opposite the close. That might be fifty or more points away from where you saw it open and trade, and also as born out by a report of time and sales.
The way they report cocoa prices is going to give a fit to a lot of candlestick traders. Why? Because they are going to see far too many "doji's" (open=close), more than are really there. Cocoa is not the only culprit, but historically, it is certainly one of the worst
When you see a completed bar on a chart, you have no idea which way prices moved first. You don't know if they moved down first or up first. You don't know whether or not prices opened and then moved to the high, went down to the low, and then traded in the lower half of the price range until the close, at which time prices soared up to the high and closed there. You have no idea of the overlap. I've seen prices trade from one extreme to the other more than once at each extreme.
In any of those instances, your protective stop could have been taken out intraday.
You know nothing of the market volatility on any given day, once you see a completed price bar. Were prices ticking their normal, exchange minimum tick, or were they ticking two or three times the minimum every time prices ticked?
Even if you purchased tick data for your simulation, showing every single tick the market made, you don't know what the volatility was. For instance, you don't know if the S&P was ticking five minimum fluctuations per tick or twenty-five minimum fluctuations per tick, and if it was doing it quickly or slowly. You don't know and you can't know, and anyone who tells you their simulated system works, based on such phony baloney, is a liar.
Not knowing how fast the market was means you can't really know what the slippage might have been. The faster the market, the greater the slippage. You can sit there and say that you would have gotten in at a certain price or that you would have exited at a certain price, but if you don't know the market volatility, and how fast the market was, you do not know enough to say that you would have done such and such. Not knowing how fast the market was, you have no way of knowing how much slippage there would have been on your entry or your exit. Without knowledge of slippage, you can't possibly know the risk.
That is also true of volatility. Volatility is made up of range of movement, speed, and tick size. If you don't know the extent of slippage, you will not know the extent of the risk you would have encountered.
As if that's not bad enough, you also don't know how thin the market was at the time you would have traded it. If you are position trading, you can't go by the reported daily volume (which is always too late to do you any good), because there is no way to know what the volume was at the time your price would have been hit. So here again you have no idea of what slippage you might have encountered, and once more you would not have known the risk.
If you want to spend your money on trading systems based upon the unknown, then you must assume the risk of doing so. Since this is a business of assuming risk, you are entitled to insure prices in any market that you care to.
Insurance companies spend a lot of money to make sure that the risks they take are actuarially sound. That is the equivalent of finding good, well-formed, liquid markets to trade in. But any market can become totally chaotic. Markets can become extremely fast, and they can become quite volatile. So even if your system was back-tested in a liquid market, when that market becomes fast and/or volatile, your back-tested, simulated system will not be able to cope with it and you will lose. It's like going out to write life insurance on a battle front.
If your back-tested, simulated system does factor in some room for fast and/or volatile markets, then, when you will be trading in slow, non-volatile markets with the built in factor, you will be utilizing a system that is totally inappropriate for the slow, non-volatile market you are in. The best you can hope for is an "optimized" system. How can you possibly expect to compete with traders who are acting and reacting to the reality that is at hand at the time?
Extensive back-testing is for historians, not traders. It is the wrong view of the markets. Your trading must be forward looking without being ridiculous about seeing into the future.
If you don't know where the next tick is, how can you possibly know where the next market turning point will be? Can you see into the future?
Maybe you like to trade astrologically. Those people are always trying to peer into the future.
In the auto business they have a saying, "There's an ass for every seat." Likewise, there's a fool for every fortuneteller who claims he can see into the future.
I guess you can always go out to your local coven and hire a witch to tell you what beans will do tomorrow. She may even be right from time to time.
You could always do as one charlatan did and run the biorhythm for each market based on the day it first started to trade. Or, you can cast the markets horoscope based on the same date. With the biorhythm, you'll know what time of day the market should be on its highs, and what time of day it will be on its lows.
You'll know which day the market will be ecstatic and reach a new high, and which day it will be down in the dumps and make a new low. However, you'll find that from time to time the market will reach new lows on the day it was supposed to reach new highs. Well, that's easy enough to explain. You can tell everyone "We've had an inversion. Until the market inverts again, the lows will be the highs, and the highs will be the lows!"
Joe Ross, trader, author, trading educator is one of the most eclectic traders in the business. His 48+ years include position trading of shares, and futures. He daytrades stock indices, currencies, and forex. He trades futures spreads and options on futures, and has written books about it all - 12 to be exact. Joe is the discoverer of The Law of Charts
, and is famous for the Ross hook and the Traders Trick Entry.
