Backtesting and Trader Psychology, Part 1 of 2
The thrill of the trade (and the potential gains that puts $ signs in everyone’s eyes) is a huge draw to the forex market. It is thrilling; you’re looking at potentially changing your entire lifestyle by changing one, seemingly simple, thing in your life. You’re going to trade for living.
We all know that it isn’t that fast or that simple. We have to allow for a learning curve. If we were to switch from one job to any other job than trading we’d expect to have to learn new skills and we’d expect that it would take a good amount of time and a whole heck of a lot of dedication.
Part of the trader’s learning curve may include backtesting. You all know that I recommend it for many reasons. I don’t recommend it as the end-all-be-all to your trading education, merely one of the many steps, however I do view it as vital to the process as a whole.
Because no two students think alike, trade alike or learn alike I’m writing Part 1 of this 2 part series today to explore the benefits of backtesting to your psychology and next week I’m going to discuss the possible detriments.
In case you’re brand new, backtesting is simply practicing your trading ideas on historical data.
One of the biggest benefits to backtesting is that it allows for quick, easy study of price action.
Whether you come to your backtesting session with a clear trading idea or not, you will learn something about price action, just by studying it. You will tune into what happens after a big wick/shadow, you’ll discover that there’s a push and pull to the market and that the market exhibits a natural corrective behavior and a plethora of other pearls that I dispense in my webinars all. the. time. But until you learn it on your own and practice your understanding of it, those little tidbits will merely be something you’ve memorized about the market and not something you understand about it.
This deeper understanding…maybe it’s really recognition of what you already know begins to the psychological development because you’re moving your theory into practice and you begin to see yourself grow into a trader with good ideas (or at least a trader who can rule out a bad idea and move onto the next possibility).
Backtesting also creates a baseline for how you’re going to apply your ideas in live conditions.
If you didn’t create that baseline, how would you ever know that what you’re doing is actual trading or if it is gambling? Having this backtested baseline in your arsenal allows you to compare your live results with something real and concrete (as opposed to something someone said should work) and it will give you the means necessary to know what needs changing, if anything, once you’re trading live. Otherwise the temptation is to change everything because you never knew what worked in the first place.
If throwing money at the market and taking hard knocks from difficult losses is one way to learn how to trade, consider backtesting the fast track.
You cannot learn all of the lessons you need in backtesting alone; however you can learn many of them. While you’re learning these lessons you’re seeing signs of progress much sooner than if you had to learn one real-time candle at a time and you’re proving to yourself that you can learn safely (sans money at risk) so…by extrapolation you’re on your way to trading safely.
This is super important to your psychology because by making the decision to trade you’re already setting off all kinds of alarm bells that pit your new Trader Self against your old Conventional Self.
These are the three biggest reasons I’ve found that backtesting helps new traders psychologically. Did I miss any? Is there some way that backtesting helped you even further?
Next week I’ll play devil’s advocate to the issue and discuss the possible detriments to backtesting – so those of you who think this is a bunch of hooey will have your chance to sound off then. 
Triffany Hammond helps traders of all levels, gain the tools, resources and guidance necessary to build on their strengths and work around their weaknesses so that they can make the best possible decisions for themselves in the Forex Market. Triffany is a regular speaker and contributor at 
Hi Triff. Excellent article. In my (limited) experience I have found that there is ‘backesting’ and there is ‘backtesting’.
In one kind you plug a series of numbers into a fancy programmed environment based on your trade criteria, push the button and count the winners, losers, ratio between the two etc. This has the advantage of quickly crunching through a large volume of data.
The other kind is to manually progress forward one bar at a time again trading based upon your methodology. This to me has the advantage of more fully involving your psychology (though even this is limited as the time and spatial movement of the bar cannot be considered). This is my preferred method as MY decision making is much more taken into consideration.
Might there be scope for a combination of both?
You’re absolutely right! There are two kinds of backtesting. I often forget about the automated kind and I certainly agree with you that it would be difficult for automated backtesting to do any good for your overall understanding or psychology.
I can see where there might be a benefit to automated BTing after you’ve spent your time developing your system and developing that deeper understanding…but I do notice that I’m a better trading when I’m also backtesting so I’d hate to ever abandon true chart analysis of historical data altogether.
Excellent thought…thanks for sharing!
Continuing from Hutch’s thoughts, I have also found that there are 2 ways of backtesting, but 2 ways in the manual kind.
Type 1 – You come up with a set of rules you’ve decided to follow then you run through the data paying only cursory attention to how you think things are going, your analysis comes only after testing a large chunk of data when you re-think if there are any tweaks you could change to improve your results – The focus of this type of testing is to run through as much quantity of data as possible with your set of rules, so that it is the quantity of data that draws you a picture of how your rules work.
Type 2 – You use your set of rules in the same way only in this type you are more scrutinous when going through the testing data to watch for subtle patterns and other factors that draw you into what makes the trade tick. This form of testing focuses not only on quantity but also on quality but of course you cannot cover as much data as in type 1. This type of testing requires you to question more during your testing while in the first type it’s more robotic.
Its the age old argument of quantity vs. quality … there is what to say for both systems advantages and disadvantage … type 1 can leave you unable to spot the smaller points but on the other hand your brain is fed far more data and you can be clearer about the answers, type 2 can often leave you over analyzing each trade making it too difficult to focus on a simple version but it can often prepare you better for live trading as you can see more in each practice trade …
Personally I am a big fan for type 1 (especially when I first started testing) and I know that Triffany is more inclined to type 2 (I think …)
How do you guys test ?
You’re right, Aby, I do prefer type 2, however it seems that very often 1 needs to develop into 2.
At first, people don’t know really what they’re watching for, but over time they start to get sparks…ideas…small details stick out and then further backtesting incorporates those.
Great observation!!
I totally agree Triffany, and backtesting (along with trader psychology) is very underrated!
I consider it an integral part of my trader’s training. How else does one have the confidence to follow their system after a string of 10, oh dear 20, even 5 losses in a row? Is this normal, is this expected?
I’m yet to get to the stage where I’m totally happy with my backtesting process, but I’ve realised it’s important that at least I start somewhere… (one of my weaknesses!!)
So for me, it often begins with an idea, where I’ll eyeball the charts and run through a small set of data (~ 100 trades) to see if there’s any validity (Aby’s Type 1). If there’s any merit, I’ll nut out some details and get more rigorous with a larger sample size and detailed statistical analyses and such. The focus on this 2nd stage being quality and quantity. Then comes forward testing and finally live if all goes well. Not often a linear process by any means, with continual monitoring and adjusting.
This is my training. This is essential.
It can be boring. It’s often monotonous. And not always fun.
There are some great and inspiring articles around on peak performance and what makes a champion/expert, which can be applied to trading. eg. Malcolm Gladwell’s 10,000 hours idea. You think of the dedication, persistence, sweat, the thousands of hours the top athletes put in to rise to the top. Am I saying it’ll take this long? Not at all. But what if it does? Could you manage it? Could you stay the distance? How far are you willing to go to be part of that 5%?
Sure, not everyone wants to be the next Market Wizard. But at least some training is required. And I consider backtesting as a crucial part of that. There’s a corny saying but one I believe to be true – Champions are made in training, not in tournaments. What do you think?
1 question I do have – how do you make it more FuN?? ;D
Looking forward to more discussion!!! And part 2!
I love the probing questions in your comments. I wish I could give every new trader a list of those and it may bring to light the real dedication this takes and that it is not something you can simply do on the side…at least not out of the starting gate.
I find that backtesting can become tedious until I’m on to something…some new trick…then it feels like a game to me…that with each new round I’m at a new level and if I can beat that round and make it better I get to move onto something that will make it even better than that.
If that doesn’t work…maybe fun isn’t the answer…maybe instead it is merely a matter of accountability…do you have anyone holding your feet to the fire?
Another little thing that made all the difference to one of my students is changing the terminology. Backtesting felt obligatory and more like homework…but he felt good about ‘practicing’. From his experience in sports he always enjoyed practice as a means to improve his performance. So, from that point on I always asked him how his practice sessions were going.
Sometimes it as simple as playing mind games with ourselves…only this time on purpose.
Yup. In many ways trading is a great window into the soul and you have to be real honest with yourself, and kind…. something which we have to be reminded of from time to time. ;p
A game. Yeah, I like that idea!
And accountability does make alot of difference. Right, I need a bigger fire lol! ;D
Love the analogy!!!
I agree, and have a similar analogy. His ‘practice’ is my ‘training’ as in my previous post. Every now and then though it get’s kinda ‘boring’ and I have to find another carrot.
I got some light bulbs though, thanks Triffany!!