Backtesting is the systematic process of finding out if a trading strategy has worked in the past and therefore will be very likely to work in the future. 

This is the most important step that a trader can go through to prove that their trading strategy actually works.

Yet, so many aspiring traders miss this vital step.

The best part about backtesting is that you don't necessarily need to know how to code to backtest.

There are many fantastic options for coders and non-coders alike.

So if you want to skip the pain of years of losing trades and blowing out accounts, keep reading to learn how to backtest a trading strategy in any market.

Does Backtesting Really Work?

In my own personal experience and from reading the experiences of hundreds of traders since I started this website in 2007, the answer is a resounding YES.

But don't take my word for it.

Watch my interviews with professional traders who have gone on to manage funds and trade full-time for themselves.

Here's an example of one of my interviews.

In addition, there are countless trading books that prove that backtesting is the best way to master a trading strategy.

Think of it this way, would you buy a used car without test driving it first?

Of course not.

You need to test it out to see if it actually runs, if the air conditioner works, and that there aren't any weird noises.

So in a similar way, you need to take a trading strategy for a “test drive” and find out its strengths and weaknesses.

But there are many more benefits to backtesting.

The Benefits of Backtesting

Here are the main benefits that you'll get out of backtesting a trading strategy.

They are all very important for building your skills, proving that a strategy has an edge in the markets and optimizing a strategy.

Performance Assessment

Backtesting allows you to evaluate the effectiveness of a trading strategy by providing statistical data on its past performance, such as win rate, average profit per trade, drawdowns, and overall profitability.

It offers a risk-free environment to evaluate the potential of a strategy.

By analyzing historical data, you can gain insights into the strategy's return on investment (ROI) and risk profile.

This is particularly valuable in identifying which strategies are likely to be profitable and which are not, enabling you to make informed decisions about where to allocate your resources.

Risk Management

Risk is one of the most important things to manage in trading.

A thorough backtest will provide the following information about the risk profile of a trading strategy:

1. Understanding Risk/Reward Ratios: It helps in understanding the risk/reward ratio of a strategy by quantifying potential losses and gains. You can see not just the profitability but also how much risk is being taken to achieve that profit.
2. Exposure to Market Conditions: Backtesting exposes a strategy to various market conditions, including high volatility periods, market downturns, and bull markets. Understanding how a strategy performs under these conditions helps you manage risk by knowing when a strategy might not perform well.
3. Setting Risk Management Parameters: Based on backtesting results, you can set stop-loss orders, take-profit levels, and position sizes that align with your risk tolerance and capital preservation goals. This ensures that trades are exited at predetermined levels to minimize losses or protect profits.
4. Statistical Analysis: It provides statistical measures of performance like the Sharpe ratio, drawdowns, and win rates. These metrics are essential for assessing the risk-adjusted returns of a strategy.
5. Risk of Ruin: This shows how likely a strategy is to have a large drawdown or blow out the entire account.

Strategy Optimization

You can use backtesting to fine-tune your strategies by adjusting different parameters and rules to improve performance and adapt to different market conditions.

Through backtesting, you can identify the optimal settings for your strategy, such as stop-loss orders, entry and exit points, and position sizing.

Adjusting these parameters based on historical performance can help in refining a strategy to achieve higher returns or to minimize risk.

Confidence Building

Doubt is the kiss of death in trading.

A well-backtested strategy can give you confidence in your approach since you have historical evidence that your strategy has been profitable in the past.

If you don't have confidence in your trading strategy, you'll mess with good trades unnecessarily and you'll probably skip many profitable trades altogether.

Just like any great athlete has confidence in their skills, traders need to build confidence in their strategies to be successful.

When you've seen a setup hundreds of times in backtesting, taking a trade becomes a no-brainer because you know what a good trade looks like.

Identifying Market Conditions

A common question from new traders is: How do I know that the market is in a trend?

Well, you learn to identify any market condition through backtesting.

This could be a ranging market, trending market or anything else.

Once you've seen a particular type of market many times, you'll get a feel for what it looks like.

Reducing Overfitting

When you backtest a trading strategy over a wide range of historical data, you can identify if the strategy is overfitted to a specific period or set of conditions.

A robust strategy should perform well across different timeframes and market environments.

One common backtesting mistake that many traders make is they only backtest and optimize their strategy over a short period of time.

Then they try to trade it in current market conditions and they wonder why it doesn't work.

The reason that it doesn't work is because the strategy was optimized over, say 1 year, but that could have been an unusually good period for that strategy.

Over the entire history of that market, that could have been the absolute best time for that strategy.

I've personally seen this happen.

So if they try to trade that strategy at any other time, it will fail miserably.

Backtesting over a long historical period ensures that a strategy is robust enough to work in many different types of markets.

Save Time, Money and Reduce Stress

Backtesting is much faster than waiting around for the markets to print candles in real time.

You can get decades worth of backtesting trades in as little as a few minutes.

Testing also allows you to evaluate a strategy without risking real capital.

More importantly, backtesting will save you the headache of jumping from strategy to strategy, while losing money along the way.

So even though it can be exciting to jump into real-money trading right away, that's always the longer route to success.

Backtesting first will seem longer initially, but is actually a shortcut. 

Emotional Discipline

Adhering to a strategy that has been rigorously backtested will make it easier to stick to your plan and make less impulsive decisions.

By testing and adhering to strategies that have shown promise in historical simulations, you'll avoid taking random, unproven trades based on emotions or market volatility.

This disciplined approach is crucial in maintaining consistency and achieving long-term profitability.

Types of Backtesting

There are 3 types of backtesting.

They will all get you a similar result, but the route you take to get that result will be different.

Each one has its benefits and downsides, so don't get too hung up on being able to do fully automated backtesting right away.

It sounds sexy.

But in reality, most people do better learning how to manually backtest first, then moving up the scale to automated backtesting…if they are so inclined.

Manual Backtesting

I feel that this is the place where most traders should start.

It's easy and anyone can do it.

Moreover, manual backtesting allows to you get very “intimate” with the data and every single trade.

In other words, you can see what each trade is doing on a very granular level and that can make it much easier to spot potential optimizations and errors.

Another benefit of manual backtesting is that most trading strategies cannot be fully automated.

There is often an element of discretion in most trading strategies, and therefore you'll have a lot more flexibility with manual backtesting.

You can use almost any trading platform to do manual testing, provided it has enough historical data.

Here's an example of a way that you can do manual backtesting for free.

Semi-Automated Backtesting

An intermediate step that not a lot of people talk about is semi-automated backtesting.

This is when you create scripts or automations that only manage part of your strategy, like the entry, the exit or the trade management.

Semi-automation allows you to speed up the backtesting process dramatically, while still being able to use the discretionary elements of a strategy.

It's a great compromise between manual and fully automated.

There are many ways to do this, but this example will get you started.

Automated Backtesting

Now we jump into fully automated backtesting.

To get the most out of this method, you'll probably have to learn how to code.

Learning to program will give you the most flexibility and allow you to control every aspect of a backtest.

There are no-code ways to do automated backtesting, but they do have their limitations.

Again, this reduces the number of strategies you can backtest because not all strategies can be turned into computer code.

Another downside is that it can be tough to see potential issues with a strategy because you aren't seeing every single trade on a chart.

But if you're a developer or engineer, this option might be very appealing to you.

There have been many successful automated traders, so don't let those facts discourage you.

The Turtles are a good example of very successful traders who use automated strategies.

How to Backtest a Trading Strategy Step-By-Step

Regardless if which method you use to backtest a trading strategy, the process is always going to be the same.

These are the steps to do your first backtest.

Step 1: Pick One Market and Timeframe

There is a misconception among many new traders that a trading strategy will work equally well in any market and on any timeframe.

Not true.

So it's best to pick one market and timeframe that you'll master, before moving on.

How do you pick the best ones?

That's a very individual choice.

There's no “best” trading market or timeframe for everyone, only the ones that you're most comfortable with.

So take some time to learn about different markets and pick the one that appeals to you the most.

Backtesting on the 4 hour chart or higher is fairly straightforward.

But day trading strategies are a little more involved so learn the details here.

Step 2: Learn Trading Strategies for Your Market

There are countless posts on forums like Reddit that show a chart and ask: Is this a good trade?

That's always painful to read because it's obvious that the person doesn't know anything about trading strategies.

Just like basketball players have their favorite moves for getting the ball in the hoop, traders need to have their favorite trading strategies to extract profit from the markets.

The fastest way to find a trading strategy to test is to see what successful traders are doing in the market you've selected.

Like with choosing a market, choosing a trading strategy will be very individualized to you.

Find a strategy that makes sense to you and that looks easy to test.

It also helps to adopt a curious mindset.

Many times traders can get too wrapped up in finding the most profitable strategy.

I've certainly been there.

But if you approach strategy selection from the standpoint of having a feeling that a strategy will work, and being genuinely curious about the results, I believe that you'll get much further than if you just look for maximum profit.

Step 3: Create a Complete Trading Plan to Backtest

Once you have a general strategy idea, it's time to turn that into a complete trading plan.

It helps a lot to write that plan down because you can reference it throughout your backtesting sessions.

When you don't have a written plan, it's too easy to stray from the plan and take random trades.

If you take random trades, you won't know how well your plan really works.

Define every element of your plan like:

• Entry criteria
• Exit criteria
• Trade management criteria
• Risk per trade
• When you trail your stop loss or move it to breakeven
• Maximum number of open trades at the same time
• If you're going to take trades in correlated markets or not

An easy way to get started is to download my free trading plan worksheet.

Step 4: Choose Your Software and Get Historical Data

Before you start testing, make sure that you have access to a lot of historical data for your chosen market.

At least 20 years of data is a good place to start.

This will determine which backtesting software or programming language you'll use.

I provide some software suggestions in the next sections.

The best software for you will depend on the market your trading.

But for now, just know that you have to test your trading plan in some sort of software platform.

You can also download historical data from third party data providers and upload it to your software.

So if you like a software solution, but it doesn't have enough data, just know that this option is available.

Step 4: Backtest

Alright, now it's time to backtest!

Start up your backtesting software and take trades according to your plan.

Most backtesting platforms will have instructions on how to do your first test.

Obviously I cannot list instructions for every single platform and programming language out there because it would make this article way too long.

So it's up to you to find the instructions for your platform.

Many people also make tutorials on YouTube, so that's another great resource.

When backtesting on the 4 hour chart or higher, then backtest with all of the data you have available.

That's fairly straightforward.

The shorter timeframes are a little harder to test.

It's not always possible to backtest all of the data because there is just too much to backtest.

In this case, pick a few different market conditions like:

• Ranging markets
• Strongly trending markets
• Weakly trending market
• Highly volatile markets

It helps to zoom out to a higher timeframe to see these types of markets.

For example, if you're backtesting on the 15 minute chart, zoom out to the 4 hour chart to see the overall market conditions.

Then within each of those periods, test a couple of years.

These “spot checks” will give you a good idea of how your strategy performs under different market conditions and if you should continue testing or not.

If your results are favorable, then you can do more in-depth backtesting.

Step 5: Review the Statistics

When you have completed a full backtest, review the results to see if the strategy has potential.

You can use a simple Excel spreadsheet to do your calculations.

Even better, if the software you're using has built-in analytics, that will save you a lot of time.

What you're looking for will depend on your goals.

Some traders look for total return, others look for consistency, and others value low risk.

Ask yourself what you value most and make that your goal. 

Step 6: See if the Results can be Optimized

Spoiler alert: Most backtests will have mediocre or losing results.

But don't get discouraged.

Almost all trading strategies will have to be tweaked and optimized to work well. 

That's the nature of the beast.

So be willing to experiment and try different ideas. 

Here are some ideas for optimizing the results of your strategy:

• Experiment with different indicator settings
• Trail your stop loss
• Target a smaller profit target
• Target a larger profit target
• Split your profit targets
• Tighten your stop loss
• Make your stop loss larger
• Add an additional indicator or criteria to enter or exit
• Don't trade on days or at times that have a high percentage of losses

Just be careful of over optimizing a strategy.

This is when you make a trading strategy work very well for the backtesting period, but it doesn't perform well in other periods.

To avoid this, it helps to split your data up into in-sample and out-of-sample data.

In other words, leave some data out of your optimization process so you can backtest on it to see if your strategy will work well in a period that hasn't been optimized for.

For example, let's say that you have 20 years of data on the daily chart.

You could backtest and optimize on 15 years of data.

Then see how that strategy works on the remaining 5 years of data that you didn't optimize for.

This is easier to do on shorter timeframes because there is much more data.

Doing this one extra step can help you understand how well your strategy will work in the future.

Step 7: Decide to Keep or Trash the Strategy

Once you've done all of the potential optimizations you can think of and the strategy still isn't as profitable as you would like, then it's time to trash the idea and move on.

That's usually very obvious.

What isn't as obvious is when a strategy is slightly profitable.

If that's the case, then test the trading strategy on multiple timeframes and multiple stocks, futures contracts or currency pairs.

Adding more trading opportunties can create a more favorable return.

You might also consider trading a portfolio of different strategies.

Each one on its own might not have a fantastic return.

But when traded together, they could be very profitable.

Backtesting in Different Markets

Each trading market has its own nuances and best practices when it comes to backtesting strategies in that market.

So now I'll give you the benefits and downsides to each market.

I'll also provide some tools and tips that can help you backtest more efficiently in each market.

Backtesting in Forex

In my experience, Forex is the easiest market to backtest.

There are only a set number of markets and some currency pairs have a long history.

The data is also easy to get and usually pretty clean.

It's also the most liquid market in the world, so there's very low slippage.

Transaction costs are also low on the major pairs.

My favorite backtesting software is NakedMarkets because it has free updated data and I can build semi-automated and fully automated strategies with the no-code interface.

Backtesting Indexes

Indexes like the S&P 500 are also easy to backtest because they have one continuous chart that goes back a long time.

To trade indexes, you can use futures, ETFs, or any other product that tracks an index.

Ease of backtesting will vary depending on which derivative you trade, but they can be a great market to trade.

I've seen some traders make a very good living just trading the S&P500 E-mini.

Great backtesting platforms are TradeStation, NinjaTrader or NakedMarkets.

Backtesting Stocks

Stocks are harder to backtest than other markets because there is a huge universe of individual stocks listed on any stock exchange.

I'm also going to group ETFs into this category because they are traded in a similar way to stocks.

On the upside, there are always many trading opportunties because there are so many stocks available to trade.

I use Amibroker, but there are many other platforms out there like TradeStation.

You can also do automated backtesting with programming languages like Python.

Backtesting Futures

Like in Forex, futures are fairly easy to backtest because there are a limited number of markets.

The biggest downside is that futures contracts expire, so there will always be a slight “jump” in the data when there is a contract change.

On top of that, you can trade different expiration months in the same contract, which can create some confusion.

Therefore, the easiest way to backtest futures is to find data that uses a continuous chart of the front month, or the contract that is going to expire the soonest.

This is usually the most liquid contract, making it less likely that you'll get choppy price action and unreliable backtesting results.

It can also help to backtest each contract individually to eliminate some of the discrepancies that can come when one contract expires and the next contract kicks in.

I've tried to backtest futures, but I found it too frustrating to navigate the contract changes.

However, there are obviously many successful futures traders out there, so don't get discouraged if you really like this market.

The premier backtesting platform for futures is TradeStation, but there are many other ones out there like NinjaTrader.

Backtesting Crypto

Since crypto is an easy market to backtest, there are many software packages that can backtest this market.

The biggest downside is that crypto is a fairly new market, so you won't have much data to test with.

Therefore, you might be better off trading a lower timeframe, or using a scale in / scale out approach.

Many markets also don't have a lot of liquidity, so you're generally better off testing the major ones like Bitcoin, Litecoin and Ethereum.

An upside to backtesting crypto is that there are very noticeable boom and bust cycles, making it somewhat easier to build strategies around.

I suggest using NakedMarkets to backtest cryptocurrencies.

Backtesting Options

Backtesting options is much different from other markets because of the way the contracts are structured and how strategies are constructed.

I'm not an expert in options, so the information here is from my research and not personal experience.

One thing that makes options hard to backtest is that there are different types of options: vanilla, binary, one-touch, double no-touch, American, European, etc.

European vanilla options are the most common, so that's generally best to start there.

Since these options can only be exercised at maturity, it provides fewer variables in backtesting.

Popular backtesting platforms are tastylive and OptionAlpha.

How Far Back Should You Backtest a Trading Strategy?

The short answer is that you should backtest as far back as possible, and with as much data as possible.

You want to see how the trading strategy performed in as many market conditions as possible.

A common meme on the internet is that you need to backtest a minimum of 100 trades to prove that a strategy works.

That's a myth.

As I detail here, the amount of trades you need to prove a trading strategy will depend on the strategy and trading timeframe.

Final Thoughts on Backtesting

So that's how to backtest a trading strategy in any market.

Remember that there's no best strategy or market for everyone.

The best combination will depend on your trading personality and what you like best.

So don't look for the “most profitable” strategy and market.

Pick the ones that make the most sense to you.

Note: You may notice that I've left a popular backtesting tool off the list, TradingView.

fThis is a fantastic platform for doing many things, but backtesting is not one of them.

You'll need to buy their higher plans to get the Deep Backtesting feature, which gives you access to more data.

In my opinion, it's not worthwhile, at least at this point in time.

The post How to Backtest a Trading Strategy in Any Market appeared first on Trading Heroes.

If you want to become a successful trader, it's important to understand the two primary types of trading strategies: discretionary and mechanical. Not understanding which one you are actually using can lead to unrealistic expectations, missed opportunities, and the belief that a strategy doesn't work, when it actually does.

I failed to understand how important this concept is when I started in 2007, so I want to save you a lot of time and frustration by helping you understand it right now.

Key Takeaways

• There are two main categories of trading strategies: discretionary and mechanical.
• Both types of strategies work, but it's important to find the one that works best for you.
• Misunderstanding your trading strategy can lead to inaccurate expectations and underperformance.

The Importance of Understanding the 2 Primary Types of Trading Strategies

Knowing which type of trading strategy you are using is crucial for 4 simple reasons.

First, you could be expecting results that are simply not possible with the type of strategy you're using.

For example, discretionary strategies cannot be traded 24/7, like mechanical ones can.

So they will have fewer opportunities to make money.

A discretionary strategy might look fantastic in backtesting, but those results might not be possible in live trading.

Second, you could be limiting your returns by hanging on to a false understanding of the type of strategy you're using.

If you're trading a discretionary strategy and you treat it like a mechanical strategy, you might be limiting your creativity and blocking out your intuition, both of which could take your performance to the next level.

On the other side of the coin, you might be introducing discretion into your mechanical strategy by turning the strategy on and off too often, thereby limiting the return.

Third, you may think that a strategy doesn't work when it does work if you adjusted your mindset.

You could backtest a mechanical strategy in one market and not be happy with the results.

However, if you traded that strategy across multiple markets and timeframes, which is very possible with mechanical strategies, the return could be significant.

That's just one example of how a small shift in your thinking can lead to big returns.

Finally, understanding the differences between the 2 types of strategies will prevent you from endlessly jumping to new strategies without properly evaluating the current strategy. 

When you know how each type works, you'll have a better idea of when to give up on a strategy and when to keep going.

Giving up too early on a good strategy, and hanging on too long to a bad strategy, are both detrimental to your success.

But many traders do it.

I've done it before and it's something I want to help you avoid. 

Now that you understand the benefits of this knowledge, let's jump into the definition of each type of strategy, and the pros and cons.

Discretionary Trading Strategies

A discretionary strategy, also known as a subjective strategy, cannot be programmed into a computer and requires the trader to use their own judgment or skill to enter and exit trades.

This type of strategy involves the use of inputs like support and resistance, chart patterns, candlestick patterns, fundamental analysis, news, or any method that requires the trader to make a relative value comparison between two or more markets.

With a discretionary strategy, you cannot expect the exact same results as someone else, as it requires input from the trader.

Your skill needs to be improved through practice and experience.

Benefits of Discretionary Strategies

There are a lot of benefits to learning and developing discretionary strategies.

Here are the best reasons to go this route.

More Flexible

Since discretionary strategies don't have rules that are set in stone, this allows more leeway in terms of how the guidelines of the strategy are applied.

You can automatically adjust for different market conditions, based on your experience.

Trading in this way can lead to more profit opportunities.

More Available Trading Strategies

There is a relatively small number of trading strategies that can be fully programmed into a computer.

So by going the discretionary route, you have more trading strategies available to you. 

You might find that exciting or overwhelming.

I personally like to have more options.

Can Take Advantage of Unique Market Opportunties

There may be world events or regulatory changes that have no president, and therefore cannot be backtested or incorporated into a mechanical strategy.

However, if you're aware, you can use your logic and previous experience to profit from the situation.

This would not be possible with a mechanical strategy that has hard and fast rules.

Downsides of Discretionary Strategies

Like with everything else, this path does have its downsides.

Here's what you need to know before you jump in.

Results Can Vary Widely Between Traders

Since there is so much trader input with discretionary strategies, backtesting and live results can vary a lot.

Some traders may say that a strategy doesn't work, while others have fantastic success with it.

The key here is to find out what the successful traders are doing and emulate that.

So if someone says that a discretionary strategy doesn't work (or does work), be sure to test it for yourself and come to your own conclusion.

Backtesting Takes Longer

Every single discretionary trade requires trader input, so backtesting usually takes significantly longer than with mechanical strategies.

This can be a benefit however, because you're able to see price action in more detail and can start to see patterns that you might otherwise not see with an automated backtest.

You can also speed up the backtesting process by using partial automation.

Harder to Optimize

Since there are more variables with a discretionary strategy, they can be harder to optimize.

You'll have to isolate each input individually and track its effect on your performance, which can be tricky.

When optimizing a strategy, it helps to track your psychological state and stick to one set of rules.

It can be easy to change the rules in the middle of a backtest or during live trading, but don't do it.

That will only make it harder to isolate and improve your rules.

More Emotions Involved

Discretionary trading requires more inputs from the trader.

So if you're having a bad day, or you aren't fully focused, then your results could be less than ideal.

There are many ways to improve your trading mindset, but it requires a lot of awareness and practice.

Mechanical Trading Strategies

A mechanical strategy, also known as a fully automated strategy, is a strategy that can be 100% programmed into a computer.

It involves a defined set of rules, and there almost no input from the trader after the development phase.

Most trading strategies cannot be made mechanical, which can be frustrating.

Additionally, mechanical trading strategies are not flexible and usually cannot change with evolving market conditions, unless there is a built-in learning capability.

Benefits of Mechanical Strategies

Mechanical strategies provide more structure to traders who like having a well defined set of rules.

It's not for everyone, but here are the benefits.

Fast Backtesting

Mechanical strategies can be programmed into a computer, making it easier to backtest and optimize them.

With just a few clicks, a strategy can be backtested over many markets and timeframes.

Many trading strategies and markets can be verified in just a couple of days.

Reproducible Results

Mechanical strategies can be reproduced between traders, unlike discretionary strategies which rely on an individual trader's skill and judgment.

Therefore, traders can work together to develop strategies, which speeds up development.

When groups of traders backtest discretionary strategies, the results can vary greatly, which can lead to a lot of doubt as to if the strategy works or not.

Easier Optimization

Since mechanical strategies are a well defined set of rules, they can be easily tweaked and tested for optimal performance.

Many backtesting platforms like MetaTrader, Forex Tester and Naked-Markets allow you to iteratively test settings like indicator values and position sizing, to find the best combination.

Testing this manually would take a long time, but you can get results from an automated backtest in as little as a few minutes.

Automation Potential

Once a mechanical strategy is developed, it can be coded into a fully automated strategy for any trading platform that allows automated trading.

All you need are the rules for the strategy and you can hire a programmer to do the rest.

Having an automated trading strategy will free up your time to develop new strategies, or do just go surfing.

Minimal Emotional Input

Mechanical strategies require minimal decision-making, reducing the impact of emotions on trading decisions.

Usually the only decision that could involve emotions is the decision to turn the strategy off or on.

This eliminates many trading decisions that can be impacted by the mood or psychology of the trader.

Downsides of Mechanical Strategies

Mechanical trading strategies have their advantages, but they also come with some downsides.

Here are the downsides that you should be aware of.

Most Trading Strategies Cannot be Made Mechanical

It's important to understand that not all trading strategies can be programmed into a computer.

In fact, most trading strategies cannot be made mechanical.

This means that it can be frustrating to find those few strategies that do work, and it can take longer to find them.

Mechanical Trading Strategies are Not Flexible

Mechanical trading strategies cannot change with evolving market conditions.

This means that if the market changes, your mechanical trading strategy may stop working, and you'll need to update the strategy or find a new one.

There can be ways to create “AI” strategies that continually learn from new data, but that is a complex process to set up and monitor.

Emotions are Still Involved

While mechanical trading strategies are often touted as a way to eliminate emotions from trading, this is not entirely true.

There are still emotions involved with mechanical trading strategies, especially when your strategy is losing.

You may feel fear and be tempted to turn the strategy off, which can lead to missed opportunities.

In my experience, the moment you turn an automated strategy off is usually when it starts to win again.

That's not always the case obviously, but it sure feels that way.

Which Type of Trading Strategy is Better?

Both discretionary and mechanical trading strategies work, but the key to success is finding the one that works best for YOU.

Some people can do both, but most people will gravitate to one or the other.

With a discretionary trading strategy, you cannot expect the exact same results as someone else.

You have to practice and improve your skills, and this will not happen just by learning a few rules.

With a mechanical trading strategy, there are minimal emotions involved, but most trading strategies cannot be made mechanical.

So there is no one best type for everyone.

The key to success to figure out which one works best with your trading personality and avoid the following common misconceptions about trading strategies.

Common Misunderstandings With Trading Strategies

Now that you understand the 2 types of strategies, this is the most important part.

Don't mix them up! 

Here are some common misunderstandings that you should avoid.

Thinking a Discretionary Strategy is Mechanical

Many traders believe that their strategy is “rules-based” and therefore mechanical, when in fact, it requires their own judgment and skill to enter and exit trades.

If you're trading a discretionary strategy and you think it's actually a mechanical one, you may give up too early on the strategy because you think the rules “don't work.”

So take some time to figure out if your strategy really is mechanical or if it's discretionary.

You'll have to backtest a discretionary strategy multiple times to get the hang of it, so don't get discouraged. You may also have to consult with successful traders using the strategy to get some pointers.

It usually takes longer to learn a discretionary strategy, so don't give up too early.

Expecting the Same Results as Someone Else With a Discretionary Strategy

With a discretionary strategy, it's important to understand that you cannot expect the exact same results as someone else.

This is because it requires the input of the trader and their own judgment and skill, which will vary from person to person.

So always test a discretionary strategy yourself, never take anyone's word that it works or doesn't work. 

Hopping to New Strategies Without Proper Evaluation

Understanding the differences between discretionary and mechanical strategies can prevent you from continually hopping to new strategies without properly evaluating each strategy.

I call this the Trading Silodrome, the perpetual cycle of jumping from strategy to strategy.

When you know how each type of strategy works, you'll evaluate your strategies accordingly:

• With a discretionary strategy you'll give yourself a little more time to figure out the nuances of the strategy and if they can be optimized.
• With a mechanical strategy you'll test as many markets, timeframes and settings as possible, before you give up on it.

If you do that, you'll know when to hold 'em and when to fold 'em.

Conclusion

On the surface, you may not think that understanding the difference between the 2 primary types of trading strategies is important.

But upon closer inspection, it's one of the most important things that you need to know about trading. 

Other trading strategy types like: trend following, price action and candlestick patterns are secondary types and are covered in deeper detail in other articles.

If you want to learn more about secondary trading strategy types, check out the related articles below.

The post Most Traders Don’t Realize There are Only TWO Types of Strategies appeared first on Trading Heroes.

Professional traders always backtest and verify their trading strategies before risking real money because their livelihood and in some cases, client money, is on the line. The average retail trader usually does not backtest their strategies and that is one of the biggest reasons that they are not able to make the transition to professional trading. 

Now that you understand the value of backtesting, I'll get into some examples of professional traders who backtest, tools you can use to backtest and the details of what backtesting does for professional traders.

Why Professional Traders Backtest

Professional traders backtest because they need to know if a trading strategy works or not. They also need to know detailed metrics about the strategy. 

It's like buying a used car.

Would you buy a used car without test driving it first?

Of course not.

In a similar fashion, a trader needs to “test drive” a strategy to find out if it has an edge. 

On top of that, backtesting gives a professional trader important information about the trading strategy.

Some of the key metrics that traders look at are: 

• Maximum drawdown
• Potential average monthly return
• Correlation to other trading strategies
• Volatility of the trading strategy
• Risk of ruin

Backtesting also helps professional traders determine the optimal position size, risk management strategy, and identify the ideal timeframe for their trades.

Examples of Professional Traders Who Backtest

Now you're probably looking for some examples.

There's actually no shortage of examples of traders who backtest, so let's take a look a few big names and one you may not have heard of before. 

If you want to learn more about these traders, do further research on your own.

Their history is fascinating. 

Richard Dennis

Richard Dennis was a highly successful commodities trader known for his Turtle Trading Experiment.

In the early 1980s, Dennis recruited a group of novice traders, taught them his trading methodology, and provided them with funds to trade.

These traders, dubbed the “Turtles,” achieved extraordinary success, demonstrating the effectiveness of Dennis's trading approach.

He was a pioneer in trend-following trading strategies and emphasized the importance of backtesting, discipline and risk management in trading.

Dennis' legacy continues to influence traders and investors worldwide, highlighting the potential for success through systematic trading methods.

Ed Seykota

Ed Seykota is a highly respected trader and pioneer in the field of computerized trading systems.

One thing that he's famous for is he used to backtest when computer programs were written on paper punch cards.

He gained fame for his exceptional performance as a trend follower and for his innovative use of technical analysis.

Ed is known for developing and implementing systematic trading strategies based on mathematical models and algorithms.

He was one of the original market wizards featured in Jack Schwager's book, “Market Wizards.”

Seykota's contributions to the field of trading, particularly in the realm of automated trading, continue to influence traders and investors worldwide.

Larry Connors

Larry Connors is a prominent trader, author, and educator known for his expertise in the field of short-term trading strategies.

He has authored several bestselling books on trading, including “Short-Term Trading Strategies That Work” and “High Probability ETF Trading.”

Connors is recognized for his research-based approach to trading and his focus on quantifiable methods.

He has developed numerous trading systems and indicators, particularly in the realm of high-probability trading setups.

Larry is highly regarded within the trading community for his contributions to the development of systematic trading methodologies.

I backtested one of his strategies here. 

Colin Jessup

Colin's story might be a little more relatable than the previous case studies.

He was working as a warehouse manager when he first started learning to trade.

From his humble beginnings, he was able to become good enough to be hired as a professional fund manager, managing a fund worth several million dollars.

On top of all that, he's a really cool guy and I had a lot of fun in this interview.

In this interview, he shares the role that backtesting had in his success.

There are Many More

But that's just a tiny sample of professional traders who backtest.

Do your own research and find more.

There are a ton of examples on YouTube.

Tools Professional Traders Use to Backtest

Professional traders use a variety of tools to backtest their trading strategies.

Some of the most popular tools used by independent professional traders include backtesting software such as NakedMarkets, MetaTrader 4, or TradeStation, and programming languages like Python or R.

These tools allow traders to automate the backtesting process, which saves them time and improves accuracy.

Spreadsheets such as Excel are also popular among professional traders because they allow traders to do custom data analysis.

When I worked at a hedge fund, they used Excel to track their trading results.

MATLAB and custom built software is used by institutional traders and hedge fund managers.

These are more sophisticated solutions that can do complex calculations and custom functions.

But regardless of the skill level you're at now, there is a backtesting solution for you. 

Conclusion

I'll say it again, professional traders backtest.

Period. 

It allows them to evaluate the effectiveness of their trading plan, indicators, and risk management.

Backtesting also enables traders to identify areas for improvement.

When backtesting, it's important to consider fees and commissions, as they can significantly impact your net profit/loss.

Optimization should be used cautiously, as over-optimization can lead to curve-fitting and poor performance in the future.

Finally, using backtesting software such as NakedMarkets and MetaTrader 5, can help you speed up your backtesting.

If you're new to backtesting, continue your education by reading this backtesting guide.

By incorporating backtesting into your trading routine, you'll dramatically increase your chances of becoming a professional trader too.

The post Do Professional Traders Backtest? appeared first on Trading Heroes.

There's a lot of argument about the minimum number of backtesting trades that you need to prove that a trading strategy really works.

Some say 30 trades…others say 100.

So who is correct?

The minimum number of backtesting trades that a trader needs to prove a that trading strategy works will depend on the timeframe the strategy is traded on, how often the strategy trades and how confident the trader is in the backtesting results.

In other words…it depends.

Since there isn't a single number that will work in all situations, I'll explain all of the factors that you need to take into account when figuring out what's the right number of trades for you.

Let's get into it…

The Myth of 100 Backtesting Trades

Before I get into what you need to prove a trading strategy works, I have to address a HUGE myth in backtesting.

I don't know where this myth came from, but it's one of the dumbest ideas in trading that many trading educators still perpetuate.

So if you're wondering why your trading isn't profitable, then this video will help you understand why a minimum of 100 backtesting trades doesn't make sense, in most scenarios.

If you prefer the text version, it's provided after the video.

Why a Minimum of 100 Backtesting Trades is Completely Ridiculous

Daylight savings time, measuring temperature in Fahrenheit and a minimum of 100 backtesting trades.

What do these things have in common?

They all don't make any sense.

Now in all fairness, I can see why someone might think that 100 backtested trades is a good number to use.

It seems about right…at least at first glance. You want to have a lot of data and 100 trades seems like a big number.

But when you really think about it, you cannot use 100 trades because that is usually too big of a number or too small.

It depends on which timeframe you're trading on.

Here are 2 examples from opposite ends of the spectrum that will illustrate my point.

When 100 Trades is Too Small

If you're backtesting a day trading strategy, 100 trades is not nearly enough to see if a strategy is reliable.

Let's say that you're backtesting a day trading strategy that averages 1 trade per day.

There are about 20 trading days per month. So if you have 20 trades per month, 100 trades will only represent 5 months.

That's not nearly enough to see how the strategy performed over several market cycles.

For example, here's the monthly chart of the S&P 500 from 1968 to 2024.

The thin vertical green box in 2013 represents about 5 months.

As you can clearly see, this a very, very small sample of the total amount of historical data.

So if you only tested during this small period of time, you won't know how well the strategy works in volatile markets, sideways markets, trending markets and quiet markets.

You might test in a really good period for the trading strategy, or you may catch a bad period.

In any case, you won't get an accurate representation of how well the strategy works over a long period of time.

When 100 Trades is Too Much

Now if you're trading on a longer timeframe like the daily chart, then 100 trades might not even be achievable.

You might not get 100 trades in 20 years.

But what if your strategy only gets 80 trades during that time and makes a ton of money on just a few trades?

This is common with trend following strategies.

They generally only produce a few trades a year, with 2 or 3 monster trades that more than make up for all of the losing trades, with a huge profit to boot.

In this case, would you insist on having a minimum of 100 backtesting trades?

Probably not.

Another scenario is if you're backtesting in a fairly new market.

It might be a cryptocurrency or a fairly new stock.

When backtesting in these markets, you might only get 30 trades.

What do you do then?

Well, it comes down to this…

How to Figure Out What's the Right Number for YOU

Now that you understand why 100 trades cannot be used as a minimum number of backtesting trades, the question becomes:

What is the best number of backtesting trades?

I wish I could give you a single, definitive number, but that's not how it works.

Like with a lot of things in trading, it really depends on the situation.

Traders need to feel confident that the backtesting results demonstrate that the strategy will work in many different market conditions.

So be sure that you have backtesting software that gives you detailed statistics on your backtesting. This is a big key to understanding how reliable a trading strategy is.

If you're day trading, you don't need to test your strategy for every single day over 20 years. But you do need to test chunks of time in different market conditions.

You may want to backtest a 1 year period in each of the following market conditions:

• Volatile market
• Quiet market
• Strongly trending market
• Weakly trending market
• Sideways market

On longer timeframe charts like the daily chart, you might want to test your strategy in multiple markets to gain confidence.

In Forex, you could test multiple currency pairs.

With stocks, you could test the strategy with many different individual stocks.

You get the idea.

Because there is no set minimum number of trades, you'll have to rely on how you feel about the results.

This will take some practice.

So when you're first starting out, don't start trading live right away.

Even if you think that you're confident in a strategy, start trading it in a demo account first. This is called forward testing.

If you get similar results in demo, then you can start trading real money.

After a few cycles like this, you'll get a feel for what good backtesting results look like and at that point, you may want to skip the demo trading step.

Conclusion

So that's how to figure out how many backtesting trades you need to prove that your trading strategy works.

You cannot say that there is a set number of minimum trades because it will really depend on the situation.

But of you follow the guidelines in this tutorial, you'll quickly get a feel for how many trades you need in each situation.

The post The Number of Backtesting Trades You Need to Prove a Strategy appeared first on Trading Heroes.

If you don't follow this process, you have almost no chance of success…and that's why about 90% of new traders ultimately fail.

So if you're willing to put in the work, but aren't sure how to proceed, then here's the roadmap.

This is the time-tested method that has worked for countless successful traders throughout history.

Follow these steps to become a successful trader:

1. Learn the basics of your market.
2. Pick a strategy that appeals to you.
3. Create a trading plan.
4. Backtest your trading plan.
5. Forward test your trading plan.
6. Journal your trades and improve.
7. Start trading live.

Now that you know the basic steps, let's dive into the details.

Learn the Basics of Your Market

The first step is to learn the basics of the market you're going to trade.

This means learning things like:

• What is being traded (currency, shares of stock, etc.)
• How to place a trade
• Transaction costs
• Loss/gain per minimum price movement
• If you can place both long and short

If you're interested in trading Forex, take this beginner's course.

I'm working on guides for other markets, but the concepts are similar in other markets.

Do some Googling and check out the fantastic videos on YouTube. There is a lot of great information out there.

Once you know the basics of the market you want to trade, it's time to learn some trading strategies.

Trading strategies are methods of trading a market that can include: technical analysis, fundamental analysis, or a combination of both. There is no single best trading strategy, all that matters is what works best for you.

So take some time to examine a few different trading strategies.

When I first started, it wasn't easy to find information on trading strategies.

I had to buy some fairly expensive books if I wanted to learn.

Now there are tons of great strategies on the internet for free. 

Again, do your own research and find resources for trading strategies.

Pick a Strategy That Appeals to You

The next step is to pick a trading strategy that appeals to you.

Many new traders want to find the perfect or most profitable trading strategy.

If you insist on trying to find such a strategy, then you're in for a long and painful trading journey.

This is a ticket to ride on the trading silodrome.

In reality, the best strategy will be the one that you understand the best, and matches your strengths/beliefs.

Yes, your trading strategy has to match your beliefs about the markets. If you believe that you'll make the most money in trends, then you'll have a difficult time trading a non-trend strategy.

Likewise, your strategy also has to match your strengths.

Some people are good at reading charts. Other people are better at analyzing fundamentals like earnings reports and balance sheets.

Pick a method that you like and makes sense to you.

If you want to learn more about which trading strategies match specific personality types, then read this.

Create a Trading Plan

Once you find a trading strategy, it's time to create a written trading plan.

Most of the trading strategies on the internet are NOT trading plans. 

A trading plan has specific rules for entering, managing and exiting trades.

In other words, you need a complete plan that will give you everything you need to place trades.

If you take a trade and you have any doubt as to how to enter the trade, manage the trade or exit the trade, then you DO NOT have a trading plan.

So before you can become a successful trader, you need to have a written plan.

Learn how to create a complete trading plan in this article.

Backtest Your Trading Plan

Congratulations!

You now have a trading plan.

This is further than most traders get, so take a minute to give yourself a pat on the back for a job well done.

But don't get too comfortable yet. This is where the hard work really begins.

Now take your trading plan and backtest it completely. When I say completely, test it on as much historical data as possible.

There's a common myth on the internet that backtesting a trading strategy 100 times proves that it works.

This is not necessarily true.

Watch this video to figure out how many backtesting trades makes sense for your situation.

Now that you understand about how many trades you need to feel comfortable with the results of your strategy, let's get into more details about the backtesting process.

You can learn how to do your first backtest here.

One final word before I leave the backtesting process…

A common backtesting mistake is to change your trading plan in the middle of the test.

Do not do this, otherwise you won't get reliable data on your trading strategy. 

It's like a doctor mixing blood samples from 2 different patients together and doing a test on the mixture. He won't be able to tell which patient has the problems that he sees in his test.

So the best thing to do is to complete your current test. Then if you want to change the rules, create a NEW trading plan, then do an entirely new test. 

Doing this will help you find a profitable trading strategy faster. 

Forward Test Your Trading Plan

Once you have a trading strategy that is profitable in backtesting, you're not done yet…

You still need to figure out how well your strategy works in real-time.

Many traders skip this step and this is another reason why so many traders fail.

So once you have a trading strategy that is profitable in backtesting, it's time to test your trading strategy in a demo account.

This is very important, so I'll repeat that. You want to do this in a DEMO account.

Backtesting is great, but it's sped up a lot.

You'll need to have some patience when you're demo trading in real-time.

By demo trading, you're getting closer to real world trading conditions and this allows you to see how well you execute your trading plan.

Learn more about how to Forward Test here.

Get Into the Habit of Journaling

While you're Forward Testing, the most important thing to do is to journal your trades.

Again, if you don't journal your trades, you'll have very little chance of success. This is because you need to figure out what you're doing wrong and what you're doing right.

Only journaling can show you these things.

Your journal doesn't have to be fancy.

Some traders geek out about having the perfect trading journal.

My advice is to start simple.

Just use a simple marble notebook, like you used in elementary school.

…or whatever works for you.

You can also use the following tools:

• Trello/Loom
• Video journal
• Evernote
• More options

Now what are you going to be writing in your journal?

Here is some valuable information that you should put in your journal:

• Open and close prices of each trade
• Edits or trade management to did while the trade was open
• Reasons for taking the trade, editing the trade and exiting
• Trade open/close screenshots
• Intuition on how the trade will work out before you open the trade
• Trading strategy you're using
• Post-trade analysis

Again, don't make it too complex. Keep it simple and you're more likely to do it.

Finally, it can also help to journal trades that you missed.

Find out why here.

Start Trading Live

Many traders jump into live trading right away and they wonder why they lose money.

Once you've honestly gone through all the steps above, it will give you maximum confidence to trade your strategy.

Only jump into live trading when you're confident that your strategy has a high probability of working in the real world.

Also make sure that you're able to execute your strategy consistently and you have addressed all of your issues related to trading psychology.

Going through the above process will also give you the historical data to understand if your strategy ever stops working.

Again, do NOT jump into live trading until you've done the previous steps and you're confident in your skills and your trading strategy.

There is a strong temptation to jump straight into live trading.

DON'T DO IT.

Follow the entire process and you'll have a much, much higher probability of success.

Final Thoughts on Becoming a Successful Trader

Many new traders think that they can learn a trading strategy in a weekend and they will become a consistently profitable trader for the rest of their life.

Nothing is further than the truth.

Just like with any other skill, there is a learning process that needs to be followed in order to become successful.

You have to practice for hours to become a good basketball player and you have to go to school for years to become a doctor.

Trading is no different. It might not take as long to become a successful trader, but you have to be willing to put in the work.

That's the roadmap.

Now get to work.

The post How to Become a Successful Trader (Step-By-Step) appeared first on Trading Heroes.

In this tutorial, I'll go over what a stop loss order is, how to implement it, and I'll answer some frequently asked questions at the end.

After you read this tutorial, you'll know everything there is to know about entering a stop loss.

What is a Stop Loss Order?

All trading platforms that I've seen have a stop loss feature.

Some are easier to use than others, but the basic function is the same.

A stop loss order is a type of order that traders use to limit their loss on a losing trade or lock in profits on a winning trade.  

To be more specific, a stop loss is a pending order that only gets executed if price hits your stop loss level.

A pending order is an order that sits on the broker's server until the conditions of the order are fulfilled. In the case of a stop loss, that condition is price hitting the stop loss price.

Once price hits your stop loss price, it turns into a market order, which means that it will execute the trade at the next available opportunity.

That means that there has to be someone in the market who is willing to take the other side of your trade.

In very large (liquid) markets, the trade usually gets filled very quickly and at the price you set. Some examples of markets are large cap stocks, Forex and large cap cryptos like Bitcoin.

However, in small (illiquid) markets, the price that your trade finally executes at might be different from the price that you set your stop loss at. This is called slippage. Some commonly illiquid markets are options, micro cap stocks and altcoins.

If you're trading in an illiquid market, find out if you can enter a stop loss that turns into a limit order instead of a market order.

A stop-limit allows you to set a limit price so you won't lose money if the only available trade is at a price that worse than your limit price.

Not all trading platforms offer stop-limit orders, so be aware of potential slippage before place your stop loss orders.

Traders usually enter a stop loss at the same time that they open a trade.

How to Place a Stop Loss to Limit Losses

The most common use of a stop loss order is to do as its name suggests.

It will limit the loss that you have on a trade.

In the chart above, the red line at the bottom of the chart represents a good place to enter a stop loss order for a long trade.

The trade would be entered at 0.63264 and the stop loss would be at 0.61617.

If price goes lower than 0.61617, then the long trade will be closed.

A stop loss order allows a trader to automatically exit a trade at a predetermined amount of loss, thereby protecting the rest of their trading capital.

Many traders use a percentage loss stop loss which risks only X% per trade. A common amount to risk per trade is 1%.

If you risk 1% per trade, you would have to be wrong 100 times in a row to lose all your money.

Even if you were just guessing, I don't think that you could be wrong 100 times in a row.

Therefore, using a stop loss protects your capital when you're wrong, so you'll be able to take advantage of the times when you're right.

How to Use Stop Losses to Protect Profits

You can also use a stop loss to protect profits.

Let's take a look at the same trade above, but this time, price has moved into profit.

The blue line is the trade entry price and the red line is the new stop loss level.

To protect your profits, you could move your stop loss up to 0.63634, locking in 37.4 pips of profit on the trade.

Moving your stop loss to lock in profit is a great way to ensure that you'll make money on the trade, but also gives you the opportunity to make even more money if the market locks into a strong trend.

Regardless of what happens though, you'll have peace of mind knowing that you've locked in a guaranteed profit.

How to Place a Stop Loss Order on Popular Trading Platforms

Stop loss orders are usually easy to place.

All trading platforms allow you to place a stop loss when you enter a trade. After you enter a trade, you can also edit your stop loss, or enter one if you forgot.

I'll give you a few examples from different trading platforms, so you can see the process in action.

How to Place a Stop Loss in MetaTrader

The MetaTrader order entry screen has a stop loss field just below the volume field.

An easy way to enter a stop loss price is to first click either the up or down arrow next to the stop loss price.

This will automatically enter a price that's close to the current price. Then you can manually edit the price to set your stop loss.

Using this method will save you time and is particularly useful for day traders who need to enter orders quickly.

The process is almost exactly the same in MetaTrader 5. If you want to learn how to set a stop loss and take profit in MT5, read this tutorial.

How to Place a Stop Loss in TradingView

TradingView has the best stop loss screen that I've ever seen.

It allows you to set a stop loss in pips/dollars, at a certain price, or by percentage risk.

To enter an order, right-click on any chart and click on:

Trade > Create new order…

Then the order entry box will appear. Check the box next to Stop Loss and enter your stop loss in your preferred format.

Finally, click on the Buy or Sell button and your order is placed.

How to Place a Stop Loss in thinkorswim

TD Ameritrade has a couple of different trading platforms that you can use, but I'll show you the thinkorswim example because it's the simplest.

Entering a stop loss is pretty complex on this platform, but it's easy once you know how to do it.

While you're entering your entry order, click on Advanced Orders > 1st trgrs OCO.

This will enter a stop loss order once your trade gets filled.

To get a complete tutorial on how the platform works, watch this video.

It shows an older version of the software, but the core principles are the same.

Yeah, I don't know why they make it so complicated.

But now you know how to do it.

How to Place a Stop Loss in Binance

The process of setting a stop loss order in cryptocurrency can vary greatly by exchange.

In this example, I'll show you how to use Binance because it's one of the most popular exchanges.

On Binance, you'll be using the Stop-limit function.

Although this example will be shown on Binance, check with your specific exchange on how to set a stop loss on your trading platform or exchange.

Here's a complete tutorial on how to set a stop loss on the Binance trading platform.

Where Should You Place Your Stop Loss?

Now that you know how to place a stop loss, this is the next question that new traders ask.

Knowing where to place your stop loss comes with practice.

You want to put it in a place where it won't be triggered by normal market fluctuations.

But you also want to set it as tight as possible to make maximum return on your trade.

It's a balancing act.

To learn where to place your stop loss, read this tutorial.

Should You Move Your Stop Loss?

Moving your stop loss to increase your risk means that you'll have a bigger loss than you originally planned for.

That's a recipe for disaster.

There is only one situation when you should move your stop loss…when you want to lock in profits.

How you do this is beyond the scope of this tutorial, but you can learn how to trail you stop loss here.

When you trail your stop loss, you might make way more profit than you would have expected because you are letting your winners run and cutting your losses short.

Do Brokers Hunt Your Stop Loss?

Legitimate, regulated brokers will not hunt your stop losses. 

Who knows what dodgy, unregulated brokers do.

That's why it's important to trade with a reputable broker. 

But if you're trading with a reputable broker and you feel like your stop losses are getting picked off, then this is probably the reason.

Final Thoughts

Once you understand how to set a stop loss order in one market, you'll know how to figure out how to do it in other markets, even if the process isn't exactly the same.

Using a stop loss on your trades is the best way to limit your risk and lock in your profits. If you haven't been using stop losses, then you should really consider using them.

In all fairness, not all professional traders use stop losses.

There are also some trading strategies that perform better when you don't use a stop loss.

But the vast majority of traders and trading strategies perform better with stop losses.

So get to backtesting and figure out the best method for placing your stop loss orders.

The post How to Place a Stop Loss Order appeared first on Trading Heroes.

It limits your risk if you're wrong, and it preserves your capital so you can take advantage of the next opportunity.

This complete tutorial will show you how to calculate your risk and position size, based on your maximum risk. 

Calculate Your Stop Loss

The first step to calculating a stop loss is to measure your stop loss in pips or dollars, or whatever your chart is quoted in.

To calculate your exact stop loss, use this formula:

ABS(Entry – Stop Loss) = Risk

It doesn't matter if the risk number comes out positive or negative. Take the absolute value (ABS) of the entry price minus the stop loss price.

Let's take a look at a few examples from different markets. In each example, the line represents the stop loss.

Stock Trading Example

When you trade US stocks, the risk will be calculated in dollars.

In this example, the stop loss is at 67.50 and the entry price is 59.60.

This is a short trade, so the trade makes money when the price goes down.

So the risk is: 67.50 – 59.60 = 7.90.

Forex Trading Example

In Forex, risk is calculated in pips or pipettes, depending on how the broker quotes prices.

The price is quoted in the second currency in the pair, or the quote currency.

For example, in the EURCHF chart below, the chart is quoted in Swiss Francs since CHF is the second currency.

The stop loss is at 0.97068 and the entry price is at 0.98609.

So the risk is: 0.98609 – 0.97068 = 0.01541.

This translates into 154.1 pips of risk.

Crypto Trading Example

Crypto can be a little tricky because trading pairs are quoted in different formats, depending on which crypto is the quote currency in the pair.

This is the Monero/US Dollar pair, which is quoted in US Dollars.

The risk on this long trade is: 134.23 – 115.332 = 18.898.

Now that you have a good idea of how this works, let's take a look at how to calculate your percentage risk per trade based on your calculated stop loss.

How to Calculate Stop Loss Percentage

Once you've calculated the stop loss in quote value, now it's time to figure out your position size based on your percent risk.

This is very important because you want to keep your risk per trade constant.

If you don't keep your risk constant, you might lose too much on one trade and not make enough on the next trade to make up for the loss.

For example, let's say that you risked 3% on your first trade and it was a losing trade. Then you risked 1% on your next trade and it made a profit of 1%.

You would still be down 2%, even though you had one win and one loss.

If you risked 1% per trade and targeted 1% profit on each trade, you would have been at breakeven.

When you keep your risk per trade constant, that eliminates one variable from your trading and allows you to focus on more important things like your win rate and your return per trade.

In these examples, I'm going to assume that you have a $10,000 account and you're risking 1% per trade.

One percent of $10,000 is:

10,000 x 0.01 = $100

So all of the trades below will only take $100 of risk.

Now I'll show you how to figure out the amount of shares, units or cryptocurrency to buy or sell.

I'm going to use the same risk amounts in dollars and pips from the examples in the previous section.

Stock Trading Example

In the example above, there was 7.90 of risk per share on that stock trade.

So to get the number of shares that you should trade, simply divide the total risk you want to take ($100) by the risk per share ($7.90).

$100 / $7.90 = 12.6

Therefore, you should sell short 12 shares of stock in this example.

Forex Trading Example

It can be a little tricky to calculate your total trade size in Forex because there are different lot sizes and the risk per pip varies between currency pairs.

If you don't know anything about Forex lot sizes, you can learn about them here.

To make things easier, you can use a position size calculator like this one.

But I'll show you the calculation so you know now to do it yourself.

In the example above, the long trade has 154.1 pips of risk.

Let's just say that you want to trade micro lots. These lots have a risk of about $0.10 per pip, depending on the currency pair.

But I'll use $0.10 just for demonstration purposes.

First, multiply the pips of risk times the cost per pip.

154.1 x 0.10 = 15.4

That gives you $15.40 of risk per micro lot.

Then divide the total risk by the risk per micro lot.

$100 / $15.40 = 6.49

So in this example, you can trade 6 micro lots to only have 1% risk in your account.

Crypto Trading Example

Since this crypto chart is quoted in US dollars, the calculation is similar to the stock trading example.

$100 (total risk) / $18.898 (risk per coin) = 5.2915652

Cryptocurrency can be divided beyond 2 decimal points, so in this example, you would be able to buy 5.2915652 Monero coins.

If the coin/token you're trading is quoted in another cryptocurrency, then:

1. Calculate the risk in the quote currency
2. Convert the quote currency to US Dollars (or whatever your trading account is denominated in)
3. Divide your total risk ($100 in this example) by the risk per coin/token in US Dollars to get the number of coins/tokens to trade

That's it!

Easy.

Frequently Asked Questions

What's a Trailing Stop Order and Should You Use One?

There are several different ways that a trailing stop loss can be implemented.

They can help you lock in profits as your trade moves into profit.

You can learn about the most used types of trailing stops here.

In that article, I also show you which one to avoid.

Where Should You Set Your Stop Loss

The next question is obviously, where should you place your stop loss.

That will depend on your trading system.

If you want to see different trading strategies, then take a look at the strategies I've written about and tested.

But the basic idea is that you want to put your stop loss in a place that's not easy for the normal fluctuations of the market to get to.

At the same time, you want to put the stop loss in a place that will show you that you're wrong about the trade. 

Brokers don't hunt your stop losses.

Many new traders believe this because they get stopped out so often.

In reality, most new traders put their stop loss to close to their entry and simply get stopped out by normal volatility.

Here are 2 examples of stop loss levels that 2 traders might choose.

A newer trader will usually choose a stop that's too close to price action…

While a more experienced trader will usually select a stop loss level that's further away, as shown above.

So the bottom line is that you want to select a stop loss price that proves you're wrong, but also isn't so close to your entry that it can get stopped out easily.

Final Thoughts

A stop loss is the best way for traders to manage risk.

…especially new traders.

When you have a trading plan that includes a stop loss, you know exactly how much you'll lose if you're wrong about the trade.

If you don't have a trading plan, then learn how to create one here.

There are some trading methods that do not use stop losses, but they should only be used once you have a little experience.

The post How to Calculate a Stop Loss appeared first on Trading Heroes.

A trading strategy is considered profitable if it has a positive result in backtesting and/or forward testing. The results have to meet the return requirements of the trader, and go through a series of filters to be sure that the results are an accurate representation of real world trading conditions. 

That's a mouthful, so I'll break down everything in this tutorial.

I'll get into how to define a profitable strategy and how to do the testing to figure out the performance of a trading strategy.

Then you'll put those 2 elements together to find out if a trading strategy really is profitable or not.

Backtesting

The fastest way to figure out if a rules-based trading strategy is profitable is to backtest it. 

Backtesting can be done in any trading market.

When you can see that a trading strategy has a profitable track record over a long period of time, that's the best indication that a strategy is likely to work now and in the future.

Some people think that you need to know how to code a computer program to backtest.

That's simply not true.

You can do both manual and automated backtesting.

Anyone can backtest.

This software makes manual backtesting easy.

You can also use free charting platforms to backtest.

It's just a matter of which one is easier for you.

All profitable traders look for trading strategies that have a historical edge in the markets. 

Once you've proven that a strategy would have been profitable in the past, you'll also have key data on how that strategy performs.

You'll know things like…

• The maximum number of losing trades in a row
• The average monthly return
• The biggest drawdown
• Market conditions when the strategy works and when it doesn't
• And more

All of these data points allow you to make important decisions about the trading strategy, which I'll get into more detail later in this tutorial.

Think about cars…

We all know that certain makes and models of cars last a long time and others break down quickly.

The reason we know this is because we have historical data that shows the reliability of these cars.

For example, Toyotas are generally very reliable cars.

On the other hand, Fiats are notoriously unreliable. So much so, that many people say that Fiat stands for “Fix It Again Tony.”

If you purchased a car from a company that just started producing cars last year, you wouldn't know how reliable those cars are because they don't have a track record.

So you're taking a big risk.

In a similar way, you need to know the track record of a trading strategy before you risk real money. 

Again, backtesting is the best way to do that.

If you've never backtested before, this beginner's guide will show you how to get started and the best tools that you can use.

Backtesting also gives you one of the most important traits that a trader can have…resiliance. 

When you take a trade, you have a high level of confidence of your probability of having a winning trade.

You won't know exactly how each individual trade will work out.

But you'll know that if you take a lot of trades, X% of your trades will be profitable. 

The fastest way find that X% probability and your expected return is through backtesting.

Knowing the backtesting statistics of a trading strategy also helps you when you're on a losing streak.

All trading strategies will have a losing streaks, but you want to be able to separate a normal losing streak from a situation where your trading strategy may have stopped working.

For example, let's say that you had a maximum of 7 losing trades in a row in your backtesting.

That's normal for that strategy.

But when some traders start trading live, they freak out when they have 3 losing trades in a row and think that their system is broken.

If they have backtesting data and they reviewed their maximum losing trades in a row, they would realize that 3 losing trades in a row is well within the normal parameters of the strategy.

There's nothing to be worried about.

The same thing goes for the other data points you get in backtesting.

Therefore, having this data gives you the confidence to keep trading when you hit a rough patch. 

Forward Testing

Another way to figure out if a trading strategy is profitable is to forward test it.

This basically means that you open a demo account or “paper trade” to build a track record on a trading strategy.

Never risk real money when forward testing. 

The primary advantage of forward testing is that you'll know if a trading strategy works right now, in real-time.

On the downside, it can take a long time to collect enough data to determine if a trading strategy works or not.

I see so many new traders making the mistake of forward testing a trading strategy that they just learned, with real money and a full-sized account.

They believe that a trading strategy works because someone told them that it works.

Then they wonder why they lose money.

Never take someone's word that a strategy works, always test and verify.

If you're only going to forward test, then you need to have enough trades to give you confidence that a strategy is profitable.

Some people online say that the minimum number of trades that you need to have a properly tested system is 100 trades.

That's not true.

I talk about how to figure out the minimum number of trades in this video.

The video talks about backtesting, but the same concept applies to forward testing.

Alright, once you have a number of trades that you're comfortable with, then it's time to move on to the verification stage.

Double Check the Results

Once you have data on your trading strategy and it's profitable, then it's time to take a step back and consider if you're missing anything.

There can be assumptions that you made in testing that would not carry over to live trading.

Broker Quotes

For example, if you use data from Broker A, then you start trading live with Broker B, you might get very different results.

The reason is because the Forex market is decentralized.

So each individual broker has slightly different price quotes.

Historical data will affect lower timeframe strategies more. The slight difference in quotes usually won't have a huge effect on trading systems on the daily chart or above.

But shorter term trading strategies are more sensitive to differences in quotes because the margin for error is much smaller.

Stop losses and take profits are smaller and therefore, any deviation in price will have a larger effect on the profit and loss of every trade.

Spread

Another common thing that people overlook in testing is the spread.

This is especially true in backtesting.

If you don't factor in the spread on every trade, your strategy will look much more profitable that it would actually be in live trading.

You might think that this is common sense, but you would be surprised at how many people overlook this.

But don't stop at these 2 examples. Think of all of the things that could be different between your testing and live market conditions.

Once you're satisfied that your testing results are a good representation of live trading conditions, then it's time to ask yourself an important question…

Figure Out YOUR Definition of Profitable

Now we get into the big question…

What's your definition of profitable?

That might seem easy to answer, but it's not.

I'll start with an extreme example to illustrate my point.

Let's say that you backtested a trading strategy over a 20 year period and it made a total of 5%.

So if you started with $10,000, your total profit would be $500, or an average of $25 pear year.

Is the trading strategy profitable?

Of course.

But is it profitable enough to make a living on?

No way.

Therefore, I would not consider that trading system profitable.

I would lose money on that trading strategy, when I factor in the profit that the system produces in relation to the amount of time that I would have to spend on it.

So there are a few elements to consider when creating your definition of profitable.

• Average return per year
• Amount of time you'll spend trading the system
• Drawdown
• Risk of ruin
• Real world performance

It's all a matter of what's important to you, how much risk you're willing to accept and the return you want to make.

Everyone would love to make 800% per year, but could you handle the risk that came with that return?

For most people, the answer is no.

That brings us to another important question…

How Much can You Realistically Expect to Make Per Year in Trading?

When you first get into trading, it can be tough to know what's possible in terms of consistently and return per year.

So the best way to figure this out is to look for as many data points as possible.

Listen to interviews with professional traders.

Take a look at track records of trading systems that are similar to the one you're testing.

That will give you an idea of what's possible and probable.

…and it will give you more confidence.

Final Thoughts

That's the complete guide on how to figure out if a trading strategy is profitable or not.

As you can see, the idea of “profitable” is very much a relative term. 

What you think is an acceptable level of profit could be very different from what I consider acceptable.

You also have to factor in the risk and consistently of the strategy.

So first define the amount of profit you want get out of your live trading strategies.

Ask yourself if that number seems realistic, based on what you've seen from live trading results of similar strategies.

Then test the trading strategy so you have as much data about the strategy as possible.

From there, simply compare the results of your testing with what you feel is an acceptable return.

In real world trading, there is no magic profit number.

It's up to you to make the call.

If a trading strategy meets your criteria, then the next step is to open a small live account and start trading the strategy.

Trade the strategy for a few months to see if your live trading results are similar to your testing results.

Only move the strategy into a full-sized account after it performs well in the small account.

Alright, that's your blueprint, now get to work!

The post How to Know if a Trading Strategy is Profitable appeared first on Trading Heroes.

Technical analysis uses the historical price chart of a market to predict future price moves. Fundamental analysis looks at underlying characteristics of a market like news, balance sheets, and other financial reports. 

Which one should you use? Or should you use both?

Let's get into the details of each type of analysis, the benefits and downsides of each, and how to figure out what you should be using.

Technical Analysis

Technical analysis is basically the study of patterns on price charts.

The core belief behind technical analysis is that the behaviors of all of participants in a trading market can be seen in the price charts.

There are many types of technical analysis, but here are two of the most common methods.

Technical Analysis Examples

Support and Resistance

There are many types of technical analysis, but one of the most frequently used techniques is support and resistance.

Support and resistance are levels where price changed direction in the past, and could be an area where price reacts in the future. 

Support is a “floor” where price could turn and start heading back up.

Here's an example of a support level where price bounced off the support several times, before heading higher.

Obviously, the price will not always bounce off the support level. If the support level doesn't hold, then price is likely to go lower.

In this example, price initially bounced off the support level, but the level was broken and price headed lower.

The concept also works for resistance, which is a level above the current price action where price is likely to bounce and head down.

Here's an example of resistance on the GBPJPY chart.

Price headed down every time it hit the level.

Again, this won't always happen. But if price reacted to the level before, it's likely that it will react to it again in the future.

Although these support and resistance levels have been drawn as lines, they are more like zones. They exist between a range of prices, not at one specific price. 

Here's what it looks like on a chart.

I find it easier to draw a line, but keep in mind that price won't turn exactly at a line.

The best support and resistance levels are areas on a chart where there was a strong move away from the zone.

So you'll see big wicks on candles, or big filled candles.

To learn more about how to draw support and resistance levels correctly, read this tutorial.

Moving Averages

Another technical analysis method is to use indicators.

These are graphs that are overlayed on a chart and are created by performing mathematical calculations on price and/or trading volume. 

One of the most popular indicators is a moving average.

My favorite moving average is the exponential moving average.

Moving averages help traders visualize trends better and show how current price action relates to price action that happened in the past.

A popular moving average is the 200 simple moving average (SMA).

Here's an example of the 200 SMA on the GBPUSD chart.

As you can see, this currency pair is in a strong downtrend because it's way below the moving average.

This information is useful because it gives traders a clue as to where price could head next.

Generally speaking, when price is below the 200 SMA, it's weak, so it's more likely to go down. If it's above the 200 SMA, it's more likely to go up.

Obviously, price cannot go up or down forever.

But eventually, price will reverse or slow down enough so that the moving average will catch up to it and price will start closing above the moving average.

That can signal that the downtrend is over and there is now a bias to the long side.

Benefits of Technical Analysis

Traders like technical analysis because they can focus on the chart and not have to worry about how much to weigh fundamental factors in their trading decisions.

Let's look at trading cocoa commodity futures as an example.

If you're using fundamental analysis, you might analyze the cocoa market by looking at:

• The weather in cocoa producing countries
• How much each country produces
• How much each country has planted
• The cost to ship cocoa
• Taxes on cocoa
• How much cocoa companies are buying
• And more

So with all of the fundamental factors that can potentially affect the price of cocoa, which ones do you focus on?

Is the weather most important?

Should you focus more on cocoa production?

It's tough to know.

But if you use technical analysis alone, you just have to look at the chart and follow your technical trading strategy.

For example, some traders use the Golden/Death Cross trading method.

The trading method is simple.

Place a trade every time the moving averages cross over.

No fundamental analysis necessary.

Other traders like using the RSI indicator.

There are many different technical trading strategies out there.

Find one that meets your risk/reward criteria and backtest it to be sure it works.

That's another huge benefit to technical analysis. You can backtest trading strategies to see how they would have performed in the past.

Downsides of Technical Analysis

The biggest downside of technical analysis is that it doesn't take fundamental factors into account when making trading decisions.

So there can be situations where the technical analysis alone can look good, but the fundamental analysis would rule out the trade entirely.

For example, there are companies that are losing a ton of money every year, but have a good looking chart.

If you only used technical analysis to make a trading decision, you would only see half of the picture.

You might buy the stock based soley on the technicals.

But if you studied the fundamentals, it would have been obvious that it was not a good buy, or it should have been a very short-term trade.

Now in all fairness, you could still make money by looking at the chart alone.

However, when you don't know the fundamentals behind price movements, it can also be harder to stay in a trade because you don't know if there is a long or short bias.

You can also be caught off guard by a change in the underlying characteristics of a company, commodity or cryptocurrency project.

Fundamental Analysis

The other type of market analysis is fundamental analysis.

This is when traders examine reports, statistics and factors outside of the price chart to make trading decisions.

Analysis of these data points can give traders clues as to where price will go next.

Benefits of Fundamental Analysis

Fundamental analysis helps you understand what's going on behind the scenes at a company, project, or in a particular market.

Traders utilizing fundamental analysis will examine things like:

• Balance sheets
• Imports and exports
• Competition
• Interest rates
• News
• Commitment of Traders Report
• Team members on a project
• And more

When you know a lot of detailed information about a company or market, you're more likely to stay in a winning trade longer and cut your losses short because you know the underlying events that can affect the price.

Fundamental analysis can also help you find good deals because there can be stocks or cryptocurrency projects that are undervalued.

The only way to figure out that they are undervalued is to understand the company or project, relative to others the in that niche.

Downsides of Fundamental Analysis

The hardest part about using fundamental analysis is getting the timing right. 

For example, if you're trading stocks, a company could have negative earnings for months before the price of the stock starts to go down.

Or a company could have an amazing product that's selling well, but the stock price doesn't go up.

This happens because there are 2 different market forces at play in trading/investing:

1. The trading market for the shares
2. The supply/demand for the product itself

The product the company makes could be selling well, but if people trading the shares do not see value in it, then the value of the stock will not go up.

On the flip side, traders could feel that a company better than it really is and buy the stock, causing the price to go up.

We see this a lot when groups promote a stock heavily and cause the price of the stock to go up a lot, even though the underlying fundamentals of the company do not warrant the increase in price.

As I mentioned before, it can be difficult to figure out which fundamental factors will actually affect the price of the asset.

Therefore, fundamental analysis is much more of and art than a science, compared to technical analysis.

The same concepts apply to any trading market.

Which is Better, Technical or Fundamental Analysis?

Overall, one analysis method is not better than the other.

You have to figure out which method, or combination of methods, is best for you. 

Trading is shades of gray. 

Many new traders believe that there are a handful of trading methods that are guaranteed to make money for anyone who follows the method.

In reality, every trader has to find the trading method that works with his or her personality, and the market they are trading. 

Some traders are better at following strict technical trading strategies.

Others are better at using only fundamental analysis.

Many traders use a combination of both analysis methods.

We all have a natural inclination to seeing the world in different ways.

It's like how some people are good at sports and others are good at music.

We will each be able to spot opportunities based our our natural talents and educational backgrounds.

So if anyone tells you that one is better than the other, remember that they are speaking from their personal experience.

It's an opinion.

Find out what works for you.

Can You Use Both at the Same Time?

Although there are some traders who only use one analysis method or the other, there are many others that use a combination of both methods.

For example, when analyzing a stock, you could use technical analysis to find opportunities to buy or sell, based on the stock's chart.

At the same time, you could examine fundamental factors like the balance sheet of the company, sales projections and the company's competition.

Many traders use fundamental analysis to identify good companies to buy, then wait for favorable technical analysis to place a trade.

Or they might identify weak companies that are overvalued and look to short the stock.

Some markets are more conducive to blending technical and fundamental analysis, while others are better analyzed with one or the other.

The bottom line is that you have to find out what works best for you and the market you're trading.

This can only be discovered through doing your research, backtesting and learning from successful traders.

What Kind of Analysis is More Useful for Day Traders?

Generally speaking, technical analysis is more useful for day traders. 

The reason is that fundamental factors have less of an effect on short-term price moves.

That said, there are few fundamental factors that can affect day traders.

For example, news announcements can move the markets dramatically, in a short period of time.

Many day traders will stay out of the markets before major news announcements, because of the volatility during these times.

But some of them will trade immediately after the announcement, based on what was expected before the announcement.

Final Thoughts

So that's the difference between fundamental and technical analysis.

One analysis method is not necessarily better than the other. It really depends on your personality and the market you're trading.

First, find the method that makes the most sense to you and matches your trading personality. You might want to use a mix of both.

Next, figure out which markets can be trading profitably with that analysis method.

Finally, always test your theories to see if they actually give you an advantage.

The post Fundamental vs Technical Analysis appeared first on Trading Heroes.

But there are many ways that you can make mistakes when backtesting. If you make any of the mistakes listed below, you won't have accurate data. 

When you have faulty data, that can cause you to start trading a strategy that doesn't actually have an edge. This usually leads to frustration, losses and believing that backtesting doesn't work.

Avoid that headache by learning how to backtest properly. This video will show you how to avoid the 19 most common mistakes.

The Most Common Backtesting Mistakes

1. Not Having a Written Plan

A written plan is essential to backtesting success.

There will be times when you get caught up in backtesting and forget the rules of the strategy. This is especially true if the strategy you're testing has a lot of moving parts.

So write EVERYTHING down. Here are a few things that you should define:

• Entry signal rules
• Percent risk per trade
• Where to place the stop loss
• Profit target
• How to manage the trade
• Indicators used and settings

But there can be several other things to define, depending on the strategy you're testing. Take some time to figure out every single parameter that you would have to define to do an accurate backtest.

You can get my free trading plan worksheet here.

…or make your own. It doesn't matter which worksheet you use.

Just write down a detailed plan and follow it.

2. Altering Backtesting Trades to be Correct 90%+ of the Time

This is an interesting one.

Some traders want to have a really high win rate and will everything they can to get it.

So they fudge trades in backtesting to make themselves feel better. They roll back the chart and take trades on future knowledge of what will happen on the chart.

In reality, most trading strategies aren't going to have a really high win rate and you won't be able to catch an ideal entry all of the time.

The best strategies are robust. They make money consistently over long periods of time. 

So trying to be a high win rate trader in backtesting doesn't help you develop a robust trading strategy.

You're just fooling yourself into thinking that the system is better than it really is.

Stick to the testing plan and get an honest result.

The more your backtesting simulates live trading, the better your chances of success. 

3. Not Taking Enough Trades in Testing

I've seen several traders backtest 6 months worth of daily chart data and declare that a system has an edge.

Yeah, it has an edge in those 6 months, but what about the rest of the time?

Test your strategy with as much historical data as possible, and take as many trades as possible. Your goal is to have a robust trading strategy that will make money in different market conditions.

Optimizing a strategy to a specific time period is called curve fitting and will set you up for disaster. 

4. Not Accounting for Your Emotional State

Everyone has a bad day here and there. At the very least, we have days when we are really tired.

Just like in live trading, your mood and your emotional state will affect your backtesting.

You'll miss trades and you just won't be very sharp.

Account for your emotional state when backtesting and don't test if you aren't feeling up to it.

Also test a system a few times on different days, to account for potential distractions or off days.

5. Quitting When the Results Aren't Immediately Spectacular

Some traders quit a backtest if it isn't profitable within the first few trades.

This doesn't make sense because the beginning of a test could just be period where the system has a normal drawdown.

So stick with a test until you hit a catastrophic drawdown that would not be acceptable in live trading.

A series of 7 losses in a row and a 7% loss is not catastrophic. It doesn't feel good, but any good trading system can overcome that level of drawdown.

6. Changing the System in the Middle of a Test

This one is very common…

“I'll just make one little tweak here.”

“Oh this might work better.”

When you change a system in the middle of testing, you have contaminated data.

It's like if someone mixed apple juice and orange juice together, then gave it to you to drink, and asked you which one tastes better.

Obviously, it would be impossible to tell because you're tasting both of them at the same time.

Likewise, when you change the rules of a trading system, you don't know how your new rules would have performed in the past and you don't know how your original rules would have performed after the change.

Test each system separately and evaluate each one with complete data. 

7. Not Following the System

Some traders write down a trading system, then they don't follow it…at all.

I'm not sure why that happens. They might have a problem with authority or something.

But this almost goes without saying…almost.

Write down the rules, then test the rules as they are written.

Most traders can do this. But if you have a tendency to stray from the rules, find a way to remind yourself to stay on track.

8. Not Doing Enough Analysis After Testing and Not Having a Good Reporting System

Knowing the win rate and return of a trading system is not enough.

You have to know things like:

• Maximum drawdown
• Highest number of consecutive losing trades
• MAE and MFE
• Yearly return
• Monte Carlo simulation results
• And more!

You can get this information by using backtesting software that provides this information, or you can import your backtesting results into Excel or Google Sheets.

These additional stats will show you how to improve your system and what to expect in live trading.

9. Thinking That Live Results Will be Exactly the Same as Backtesting

Successful trading requires that we think in probabilities, not certainties. 

A trading system that looks good in backtesting may not perform exactly as we expect in live trading. There can be a few reasons for this.

For starters, you may be getting nervous when there's real money on the line and you could be doing things that you didn't do in backtesting. You might be moving your stop loss, or you may cut your winners short.

Some traders hit a drawdown when they first start trading a system live and they think that the system is broken. But in reality, if they reviewed their backtesting, they might realize that it was a normal drawdown.

Third, there might be a variable that you aren't accounting for in your backtesting. That could be the spread, trading at the wrong time of day, or something else.

Finally, there might be something about the markets that's different from when you backtested. There might be unusual news events or the markets may have fundamentally changed.

Your live trading results should be similar, but not exactly the same as your backtesting. Use your backtesting as a guide, but understand that you also have to account for a certain degree of random market fluctuations. 

10. Not Considering Portfolio and Correlation Risk

Strategies cannot be traded in a vacuum.

Even if a strategy works well on 2 Forex pairs separately, trading the strategy on both pairs at the same time might not be a good idea.

You may have to reduce your risk on each trade, or decide to only take the signals that look the best.

Trading multiple markets with the same trading strategy can dramatically amplify your drawdowns, so be sure to factor that into your backtesting.

An easy way to do this is to merge the results of both tests into one spreadsheet and analyze the results together.

11. Only Testing on 1 FX Pair/Stock/Commodity and Assuming it Will Work in All Markets

I blame this one mostly on trading educators. 

There are quite a few educators that will tell you that their trading system will work in any market.

Maybe. But I haven't found a case where that is true yet.

Each market and each individual stock, currency pair or futures contract has its own personality. They are influenced by different fundamental factors and market dynamics.

Therefore, thinking that you can test a strategy in one market and apply it to all the markets in the world is simply being lazy.

Test each market before you risk real money.

12. Being Distracted and Missing Trades

Yeah, I get it.

Backtesting can be tedious at times.

I used to play movies in the background, or listen to music while backtesting. Now I'm more conscious of what I'm doing when I backtest.

Watching movies is just a bad idea and you should be aware of the type of music you're listening to. Turn off your phone and eliminate as many potential distractions as possible. 

If you want to listen to music, understand how it affects your concentration and mood. You might like to listen to Metallica in your car, but that type of music probably isn't the best when you want to focus.

…or maybe it is.

Do you.

Awareness is always the key to improvement. Be aware of how different stimuli impact your mental state and eliminate the ones that don't help you.

At the same time, think about how to add things that do help. Maybe open a window to get some fresh air, add some decorations in your room, or listen to uplifting music.

13. Entering/Exiting Trades Optimally and Not Honestly

This one can actually go both ways.

There is something to be said for testing a system with an optimal entry.

What I mean by that is entering a trade at the point where it would make the most money and follows your plan, versus where you probably would have entered it in live market conditions.

Entering a trade according to your plan may seem black and white. But when you're testing a discretionary system, there can be big gray areas.

Many traders set the backtest speed to full-speed playback to get through as much data as possible.

Then they overrun the entry point and make trading decisions based on the data that they already saw.

You won't have the benefit of future information in live trading, so don't use it in your backtesting.

The only way that backing up and entering at the optimal point helps, is if you have very precise, mechanical entry rules.

If there is any discretion involved in your entry, like looking for a support/resistance level, then there's the temptation to scroll the chart back to the ideal entry.

To prevent this, look for backtesting software that only allows you to move forward on the charts. This will keep you honest. 

14. Only Following Other People's Rules and Not Experimenting for Yourself

Predefined trading systems usually only work well for one trader.

…and that's not you.

Every single successful trader I've talked to or heard about has had to customize their strategies to fit their personality. Myself included.

So learn trading systems from successful traders. But consider those systems as a jumping off point.

When you find a system you like, be willing to customize it fits your personality and lifestyle. Play with different ideas and have fun with the process.

Your chances of success will increase dramatically when you start thinking for yourself.

15. Throwing Out a System Because it Doesn't Make X% Per Month

A monthly return goal is an expectation that may or may not be achievable by your trading system.

It can be possible to have monthly goals for day trading strategies. But for timeframes higher than that, it's almost impossible.

I think that it's much better to have a yearly goal because that gives your trading strategy room to go through a few winning and losing streaks.

So don't try to cram every trading strategy into your expectations. Your expectations are an arbitrary number anyway. 

First find out if a strategy is profitable, per your plan.

If it passes that first test, then you can experiment with versions of the entry and exit to try to increase the return.

Also remember that you can potentially use that strategy on other timeframes and in other markets to increase the return even more.

Just be sure to backtest it first. 

16. Trying to Over Optimize by Adding More Indicators/Conditions

This is a very common issue.

Humans are naturally built to want to make better versions of whatever they create.

So in search of perfection, we try to improve the win rate of trading strategies by adding more rules to a trading system, in the hope of filtering out losing trades.

Adding more indicators or conditions usually makes a trading system worse.

Your goal when developing a trading system is to find something that is as simple as possible, and is profitable over a long period of time.

Because you'll never develop something that's perfect.

17. Trying to be an Automated Trader When You Should be a Manual Trader and Vice Versa

Some people are better manual traders. Others are better at coding and are more likely to be successful trading automated programs.

Consider your skills and strengths. 

I would say that most people are better off as discretionary traders. When they find a system that is profitable, then they can do Incremental Automation and hire a programmer to automate all or parts of their strategy.

However, if you're a programmer or engineer personality type, then fully automated trading could be for you. These types of people thrive on structure and can translate trading ideas into code.

18. Not Studying the Rules of a System That You're Testing (if learned from others)

This is one that's often overlooked.

I've caught myself a few times, where I was too eager to backtest a system and jumped into testing, without studying the rules of the system closely.

Upon further review, I discovered that I had missed a few key points that could have made the strategy profitable in my backtests.

So take your time when you're learning a trading strategy. Go over the material several times to be sure you haven't missed any details. 

Then start testing.

19. Preset Bias to Prove or Disprove the System

Finally, some traders have a preconcieved notion about a trading system before they even start testing it.

For example, a trader might believe that most breakouts are destined to fail. So if they are testing a breakout system, they might cut the winners short because they want to capture profits as soon as possible.

The bottom line is to leave your biases at the door.

Follow the plan exactly and don't think that you know better.

Final Thoughts on Backtesting Mistakes

Even experienced traders can sometimes make these mistakes, so always be aware while you're testing and try to be as scientific as possible during the process.

If you follow these guidelines, you'll be rewarded with quality data that will help you improve your trading performance.

Break the rules and you could be spinning your wheels on the Trading Silodrome for years.

It's your choice.

The post 19 Backtesting Mistakes Beginners Make appeared first on Trading Heroes.

A pip is the smallest price move in the Forex market. It is short for “price interest point.” In currency pairs that don't have the Japanese Yen in it, 1 pip is a 0.0001 change in the price of the currency. When the Japanese Yen is one of the currencies in a pair, 1 pip is a 0.01 change in the price. Smaller price changes are called pipettes. 

This video will give you more examples on how calculate your profit and loss in pips.

How to Calculate Profit and Loss in Pips

Calculating your profit and loss on a trade starts with calculating the number of pips that you've made or lost.

Here's how you do it:

Step 1: Subtract the Open From the Close

To illustrate how this works, I'm going to use a theoretical example trade:

• Long
• EURUSD
• Open price: 1.18443
• Close price: 1.18555

The price you start with will depend on if you went long or short.

If you opened the trade by going long (buy), then you'll start with the trade close price.

When you open a trade with a short (sell), you start with the trade open price.

Then subtract the other price to get your profit and loss in pips.

So in our example above, since that trade was a long, I'll start with the trade close price: 1.18555

Then I'll subtract the open price: 1.18555 – 1.18443 = 0.00112.

Since that's a positive number, that means the trade was profitable. This makes sense, since the close was higher than the open, on a long trade. A negative number means that you have a losing trade. 

I know this is probably obvious to you.

But there will be people who ask why I start with the close for a long and the open for a short.

So I'm including that information to make this a complete tutorial for beginners.

Step 2: Multiply by a Constant to Get Number of Pips

Alright, since this is a non-JPY pair, we multiply the number by 10,000 to get the number of pips: 0.00112 X 10,000 = 11.2.

So on this trade, there was a profit of 11.2 pips. 

When dealing with JPY pairs, you would multiply by 100 in the last step to get the number of pips profit or loss.

That's it!

What's a Pipette?

A pipette is a fraction of a pip, 1/10 of a pip, to be exact.

Many brokers quote prices in pipettes to help give their customers tighter spreads.

For example, if a broker used only whole pips, the spread on the EURUSD could only be 1 or 2.

But with pipettes, they can provide a spread of 1.5 pips, potentially saving you 0.5 pips on every trade.

Another way to think of a pipette is like a fraction of a penny in the US stock market.

The smallest price move in a stock is 1 penny.

However, in 2005 the SEC created Rule 612. This rule states that stocks worth less than $1 have to be quoted in minimum increments of $0.0001.

So this fraction of a penny is similar to a pipette, which is a fraction of a pip.

How Many Pips a Day is Good?

This is a common question among new traders and I understand where they are coming from.

However, setting a pip goal is not useful in real-world trading.

Here's why…

What really matters in tracking your trading performance is your percentage gain or loss per trade. 

Dollar amounts don't matter, pips don't matter and number of trades don't matter.

All that matters is if you're managing your risk correctly by taking the right trade size for your account.

For example, let's say that you made 50 pips on a trade and you have a $10,000 account.

Well, how much money is that?

What percentage of your account is that?

There's no connection between those 50 pips and your $10,000 account.

However, when you calculate how much you gained on that trade, then you can start to understand how much of an impact that trade had on your account and if that was a good amount to risk, based on your backtesting.

So in order to find out your percentage gain on your account you would do the following: 

(pips profit or loss) X (cost per pip, per lot) X (number of lots) = $ profit or loss

Your trade might look something like this…

(50 pips profit) X ($0.10 per pip, per mini lot) X (10 mini lots) = +$50 profit

Then divide the profit by the total account balance to get your percentage profit:

$50 / $10,000 = 0.5% profit.

Now we can see that 50 pips of profit was actually a very small gain, in relation to the total size of the account.

So you might want to risk more on future trades.

But always backtest before making changes to your strategy.

Conclusion

So that's how pips work in the Forex market.

They are the starting point for calculating your profit and loss on a trade, but they are not an important metric when tracking performance.

I can always spot someone who doesn't actually trade when they create a trading journal or trading report that tracks pips

If you want to improve your trading, stick to tracking your percent gain or loss.

That's the most important metric. 

The post What is a Pip in Forex Trading? appeared first on Trading Heroes.

Lot sizing is a little different in Forex, compared to other markets, but once you figure it out, it's actually quite simple.

I'll also show you why lot sizing is very important in trading and how to choose a broker based on the lot sizes they provide.

The Hierarchy of Success in Trading

Before I get started on lot sizes, it's important to understand why lot sizes are important. 

They are important because they are major element of risk management.

Success in trading is determined by prioritizing the following elements of trading…in this order of most to least important.

1. Trading Psychology
2. Risk Management
3. Trading Strategy

However, most beginning traders have a priority list that looks like this:

1. Trading System
2. Trading System
3. Trading System
4. Trading System
5. Trading Psychology/Risk Management

…and that's why most aspiring traders fail.

Risk management is much more important to your success than your trading strategy, so pay attention to your risk per trade and your lot sizes.

This video will explain how Forex lots work.

What is a Pip?

You'll need to understand the concept of pips in Forex to calculate risk, so I'll cover that briefly before we move on. If you understand this already, feel free to skip down to the next section.

There are basically 2 types of price quotes in commonly traded Forex pairs.

• Pairs with Japanese Yen in the pair
• Pairs without Japanese Yen in the pair

Yen pairs are quoted in 2 or 3 decimal places. The 2nd decimal is a full pip and the 3rd decimal is a pipette, or fraction of a pip. It's like a fraction of a cent in stock share prices.

Pairs that don't have Yen in them are quoted in 4 or 5 decimals. The 4th decimal is the full pip and the 5th decimal is the pipette.

Here are 2 examples of how you would calculate pips for each of the types of pairs.

Currency Units by Lot Size

Minimum lot sizes are easier to understand in other markets because it's usually 1.

Here are a few examples:

• 1 Share of stock
• 1 Futures contract
• 1 Options contract

But in Forex, there are some preset “packages” of lot size units.

These are the lot sizes that are available in Forex:

• Standard Lot: 100,000 currency units (lot size of 1 in MetaTrader)
• Mini Lot: 10,000 currency units (lot size of 0.1 in MetaTrader)
• Micro Lot: 1,000 currency units (lot size of 0.01 in MetaTrader)
• Nano Lot: 1 currency unit (lot size of 1 in TradingView/Oanda, not available in MetaTrader)

This is great in theory, but what does it mean in live trading? Well, it might be easier to think of lot size in terms of profit/loss per pip.

Keep in mind that the value per pip will vary by broker and currency pair. But I'll use the EURUSD as an example because the pip value is generally pretty similar across all brokers, and it's usually a nice round number.

• Standard Lot: $10/pip
• Mini Lot: $1/pip
• Micro Lot: $0.1/pip
• Nano Lot: $0.0001/pip

How to Figure Out Which Lot Size to Use

To find out the correct lot size to use on each, you can use a lot size calculator like this one. Most brokers have one available.

If you can't find a calculator on your broker's website, contact their support and they can point you in the right direction.

In order to calculate the correct lot size, enter the information about your trade. In the margin field, enter the maximum risk that you want to take on this trade.

Remember that Oanda uses nano lots, so the number of units will be a little different than if you used a calculator that was built for MetaTrader or another trading platform. Use the table in the previous section to convert nano lots to mini, micro or standard lots.

For example, let's say that you have a $10,000 account and you want to risk 1% on a trade, which is a $100 of risk per trade.

Your calculator will look like this:

Since Oanda uses nano lots, the maximum trade size is 4,244 nano lots or 4 micro lots, if you round down. If you choose to round up, then you would take the trade with 5 micro lots.

Herein lies the issue with brokers that do not use nano lots. 

When a broker only offers mini or micro lots, then  you have to round up or round down. This means that you will be risking more or less than is optimal for your account.

Over time, this can have a detrimental effect on your account because you aren't risking a consistent amount per trade. So some winning trades won't make up for the losing trades.

How to Choose a Broker Based on Lot Size

Choosing a broker based on the lot size that they offer is pretty easy. Start by calculating how much money you'll be risking per trade. 

For example, if you have a $1,000 account and you want to risk only 1% per trade, then you'll be risking $10 per trade. Now go back to the pip value list in the previous section and how many pips that would be for the EURUSD, for each of the lot sizes.

This example would be as follows:

• Standard lot: $10 (risk per trade) / $10 (pip value) = 1 pip of risk
• Mini lot: $10 (risk per trade) / $1 (pip value) = 10 pips of risk
• Micro lot: $10 (risk per trade) / $0.1 (pip value) = 100 pips of risk
• Nano lot: $10 (risk per trade) / $$0.0001 (pip value) = 100,000 pips of risk

Then figure out the maximum number of pips you'll be risking on your trades. If you're day trading and only going to be risking 100 pips or less, then you could potentially get away with a micro lot account.

But if you will be risking more than 100 pips, then it's better to go with a nano lot account.

However, if you have a bigger account, like $100,000, then a micro lot account is probably a good size to trade.

You'll have to make your decisions on which lot size is right for you, but knowing the right lot size before your first trade will get you started on the right foot. 

First-In First-Out and Hedging

There are a couple of other terms that you may hear, in relation to lot sizes and entering trades in Forex. They can be a little confusing when you're first starting out, so I want to make you aware of them.

First-In First-Out (FIFO)

In non-US brokers, you can enter and exit positions as you please. This is the way that it should be.

However, if you have a US based account, you'll have to exit your trades in the order that you entered them. 

So let's say that you enter 2 Japanese Yen trades as follows:

• Trade 1: Long 2 mini lots
• Trade 2: Long 1 mini lot

If you have to follow the FIFO rules, then you would have to exit trade 1 before you exit trade 2. Some US brokers will also blend your trades, so you'll only see an average of the 2 trades, not 2 separate trades.

I'm not a fan of FIFO, but there are ways around it. You can read this post on how to do it.

Hedging

Hedging is when your broker allows you to hold both long and short positions in the same trading account.

Again, US based accounts cannot do this, but traders in the rest of the work can. There is a way around it, but some traders may not need it.

Final Thoughts on Forex Lot Sizes

Lot sizes are an important component of risk management. Understanding how your broker and trading style affect the lot you use is one of the first things that you should learn in trading.

If you use the correct amount of risk per trade, you'll be able to stick around longer and figure out the trading game. Use too much risk and you'll blow out your account and be forced onto the sidelines.

Take a few minutes to figure out your ideal lot size right now. 

The post Forex Lot Sizes Explained (Complete Beginner’s Guide) appeared first on Trading Heroes.