How to Backtest Trading Systems, Part 1

Summary

In this video, Rob Booker discusses the importance of backtesting in trading, emphasizing it as a tool for gaining confidence rather than predicting profitability. He introduces the Knoxville Divergence indicator and explains how to use it in backtesting. Rob challenges common backtesting criticisms, advocating for manual backtesting to understand system performance, especially during drawdowns. He stresses the need to be honest with oneself and to focus on the worst-case scenarios to truly refine a trading system. The video concludes with a prize giveaway and a call to action for viewers to engage with the content.

Takeaways

• 😀 Rob Booker emphasizes that backtesting is about gaining confidence in a trading system rather than guaranteeing profitability.
• 🔍 Backtesting can reveal potential flaws in a system by examining how it performs under various market conditions, including periods of failure.
• 📈 The Knoxville Divergence indicator is introduced as an early warning sign for potential price reversals, which can be backtested for effectiveness.
• 🤔 Booker questions the conventional wisdom that backtesting provides accurate expectations for future performance, suggesting it's more about understanding system behavior.
• 📉 He discusses the importance of considering drawdowns and the psychological 'pain' of losses when backtesting, which are often overlooked in favor of win rates.
• 🛠 The concept of manual backtesting is introduced, where traders document rules and test them on historical data to refine their trading systems.
• 🏆 Booker highlights the value of focusing on the worst-case scenarios in backtesting to identify areas for improvement and to build more robust trading strategies.
• 💡 He suggests that skepticism and doubt are essential for developing effective trading systems, as they encourage traders to question and improve upon existing strategies.
• 📝 The necessity of creating a standard operating procedure for trading is mentioned, which helps in systematically applying and testing trading rules.
• 🎁 The script concludes with an interactive segment where a viewer is rewarded for engagement, showcasing the community aspect of the trading discussion.

Q & A

What is the main topic of discussion in the video?

The main topic of discussion in the video is backtesting in trading, specifically the process and its limitations.

Who is the speaker in the video?

The speaker in the video is Rob Booker, who is discussing backtesting and its role in trading.

What is Rob Booker's view on the accuracy of backtesting?

Rob Booker expresses skepticism about the accuracy of backtesting, suggesting that it may not always be a reliable indicator of future performance due to the potential for systems to fail eventually.

What is the purpose of backtesting according to Rob Booker?

According to Rob Booker, the purpose of backtesting is to gain confidence in one's trading system, rather than to predict profitability with certainty.

What does Rob Booker suggest is a common misconception about backtesting?

Rob Booker suggests that a common misconception is that backtesting can accurately predict average profit, average loss, and win percentage, which he does not necessarily agree with.

What is 'Knoxville Divergence' mentioned in the script?

Knoxville Divergence is an indicator used by Rob Booker that serves as an early warning sign for potential price reversals in trading.

Why does Rob Booker emphasize the importance of looking at failures during backtesting?

Rob Booker emphasizes looking at failures during backtesting to understand the pain and drawdowns associated with a trading system, which can help in developing a more robust and realistic trading strategy.

What is the criticism Rob Booker addresses about backtesting?

The criticism addressed is that backtesting can be seen as invalid or 'faking it' because one can see what already happened, which might encourage traders to be dishonest in their testing.

What does Rob Booker suggest traders should do with their trading systems when they encounter a period of multiple losses?

Rob Booker suggests that when encountering a period of multiple losses, traders should find a way to turn that into a learning experience, possibly by adjusting their trade size or strategy to manage the drawdowns effectively.

What is the significance of the 'Trifecta' system mentioned in the video?

The 'Trifecta' system is a trading system built by Rob Booker that looks for divergences as a signal for trades. It is used as an example to discuss the importance of manual backtesting and the potential for traders to adapt and improve upon it.

What does Rob Booker advise about the use of platitudes and tropes in trading systems?

Rob Booker advises against relying solely on platitudes and tropes in trading systems, as they do not constitute a solid strategy and can lead to an 'unhappy existence' if applied without critical examination.