Difference between Backtesting and Other Methods of Analysis

Hey, Adrian, here again, founder of Enlightened Stock Trading. And in this video series, we're talking about backtesting. And in this video particularly, what I want to talk about is the difference between backtesting and other methods of analysis. Now, you might be wondering what is backtesting and should I do that, or should I just look at my charts and go back in time manually on my charts and really watch and investigate how my indicators move and perform and find the entries and exits and get a feel for my strategy that way. Or maybe I should just paper trade my strategy and collect a large number of trades through paper trading and use that as a method of evaluating whether my strategy is profitable. And then the third thing I want to cover is single instrument backtesting versus portfolio backtesting and why you would do one versus the other. But before we go any further, make sure you hit the subscribe button and give this video a thumbs up so that you get notified of all of my future videos, because I've got new trading content coming out all the time and I don't want you to miss a thing. Okay, so let's start with backtesting versus chart replay. Because when I deal with new technical traders, one of the most common methods of analysis that I see traders using is chart replay analysis. What that is, is you pull up the chart of the instrument you want to trade and you put all your indicators on there. And then you go back in time and you go forward bar by bar, watching the indicators and how they move and finding the buy signals and the sell signals. And in your journal or in your spreadsheet, you record the the buy signals and the sell signals, and you monitor how profitable that strategy was by working through the chart, bar by bar, and finding all of the trades that it generates. It's a form of backtesting. But what I'm going to say is that it's really slow and cumbersome because what it does, what you're doing, is looking on a single instrument, on a single chart over a fairly discreet period of time, a fairly limited period of time, and finding a small number of signals to determine whether or not or to judge whether or not that strategy is profitable. Contrast that with backtesting using trading software, where you might put your rules into the trading software and then go back over 30 years of market history, over thousands of stocks, and generate thousands or tens of thousands of trades and assemble those into a portfolio. That that shows you the equity curve of how that strategy makes money over time. That's what systematic backtesting is compared to chartreplay. So you can see that with chart replay, you get some information about the strategy, small number of trades from a small number of stocks over a narrow time window. But with backtesting, what you get is a large amount of information about the trading strategy, large amount of history, large number of stocks or instruments, large amount of trades, large volume of trades. So backtesting correctly gives you a far bigger.

Sample set to analyze, far more experience with that trading strategy to determine whether it's profitable, whether it's stable, whether it's robust. So if you're thinking about, should I backtest or should I do chart replay, it's chalk and cheese. The answer is clear. You need to backtest properly. Just doing it on the charts is leaving way too much information on the table. And let me tell you, your competition in the markets is not just doing chart replay analysis to determine whether their strategy is profitable. Your competition in the market is intensively backtesting their trading strategies, really interrogating performance over a lot of data to determine whether their strategy is profitable. And if you're just doing chart replay, you're at a distinct disadvantage compared to someone who's backtested. Okay, the next type of analysis that is very, very common in the trading world is paper trading. So let's talk about paper trading versus backtesting. First of all, what is paper trading? Paper trading is where you get your trading rules and in real time, you generate the signals from those rules. You journal, or you put them into a demo account or a dummy account and take the buys and sells in real time as they unfold, as the markets unfold. Doing paper trading is great because it gives you a feel for how the signals come, how frequently how it feels when those signals are generated and how those signals play out, how those trades play out in real time. So it's great for getting a feel for the market. It's also great for checking your trading process, making sure that you know what step to do when and getting that process all nice and smooth. So paper trading is really quite useful. But what paper trading doesn't do well is give you an indication of whether or not the strategy is profitable. Now, why not? Paper trading, just like chart replay, only gives you a very small amount of data, because if you're exceedingly patient, maybe you can paper trade for a couple of months, maybe you can generate 50 or 100 trades. And in fact, most traders I've worked with or I've spoken to who have tried paper trading before coming to enlightened Stock trading have maybe done it for a month or two and maybe generated 30 or 50 trades over a very short period of time. Now, that's chronically insufficient.

To give you an idea of whether the strategy is profitable. Here's why. The market moves through primary bull markets, sideways markets, and primary bear markets. A bull market could take five to seven years to play out. The market could move sideways for several years, and the market could be in a bear market phase for between one and three years, typically maybe longer, depending on which market we're talking about. And if you're paper trading and you happen to be in a bull market, then you're going to get, if you're trading on the long side, at least you're going to get some really good signals and you're going to think that the strategy is really profitable. But paper trading in a bull market tells you absolutely zero about how well that strategy will perform in a bear market. So we got to make sure that we fully understand the profitability and the performance of the strategy. Paper trading only tells you about the performance of the strategy in the market conditions under which you paper trade. But we know that you have to trade for a long time to go through all of the different market cycles. If you want to get all the information you need from paper trading, you're going to have to paper trade for years and generate thousands of trades. Because you need to know how your strategy performs in bull markets, in sideways markets, in bear markets, during high inflation, during low inflation, during rising interest rates, during falling interest rates, during peace, during war, during pandemic, during all of these things. And to get all of that information through paper trading is just impractical. That's where backtesting comes in. Because with backtesting, you can put your rules into the trading software. You can apply those rules to the past 30 plus years of market history, and you can generate all of the signals that that strategy would have generated and assemble a portfolio and see how it performs over time. Generate the equity curve, the trade statistics, all of the ratios that you want to use to evaluate the performance of your strategy. That tells you the answer to whether or not your strategy is profitable in all of those different market conditions. Paper trading just never will. So that's why backtesting is so important. Paper trading has its place, but it's only to understand the dynamics of how it feels to place those trades and to smooth out and refine your daily trading process, not to build confidence that the strategy is actually profitable. Okay, the third style of analysis that I want to Talk about is single instrument backtesting versus portfolio backtesting. And oftentimes this is really driven by the trading software that you might use. So for example, a lot of traders start on TradingView, which is free software. And TradingView is great, has really good charting. It even allows you to do some backtesting if you learn Pine Script. However, it only allows you to test a single instrument at a time. And there's many other trading softwares that only allow you to test a single instrument at a time. But if you trade stocks or crypto, typically you're not just going to apply a strategy to one system. You have what's called a portfolio system. So for instance, I have a lot of trend following systems for stocks, and in trend following for stocks, you don't trade just one stock, you trade the entire universe of stocks. So I apply my trend following rules to the entire Australian market, for example, and my rules will pick out which stocks are trending according to my rules now, and it will prioritize those stocks according to my predefined rules. And it'll buy the stocks that are trending the most strongly. It'll then hold those stocks until an exit signal is generated. When an exit signal is generated, some cash becomes available which can be reinvested into a new stock which which is currently trending at that point in time. So portfolio back testing allows you to apply the rules to the entire market and assemble a portfolio of stocks or other instruments and evaluate how that portfolio would have performed. Now this is the way most of us trade in the stocks world, in Forex or in futures. Often single instrument back testing is okay because you apply one strategy to one market, one ticker. And if that's the way you trade, then single instrument backtesting is okay. But if you're trading in stocks and holding a basket of stocks or a portfolio of stocks, then portfolio back testing is what you need to do. So all back testing is not, all backtesting methods are not created equal and all back testing software is not created equal. So if you're trading stocks, chances are you're going to need portfolio backtesting software. If you're trading forex or futures, then probably single instrument backtesting will do the job. Now the great thing about portfolio backtesting software is that it can also test single instrument strategies. But single instrument back testing software cannot effectively test portfolio strategies. So that's the difference between single instrument and portfolio. Most traders should have portfolio backtesting software unless you're absolutely certain you're only going to trade one strategy with one ticker. So there are the three different types of analysis that I want to share with you today. We talked about backtesting versus Chart replay. We've talked about backtesting versus Paper trading, and we've talked about single instrument back testing versus Portfolio backtesting. All important things to understand on your journey to master this really, really important topic. Topic. So backtesting is one of the most important tools for you to learn in your trading tool belt. It will give you an advantage over other traders and it will give you a level of confidence that you can't possibly achieve with any other method of analysis. So that's the end of this section. In the next video, I'm going to talk about backtesting different types of instruments. So watch the next video in this series. Or if you're on my blog, scroll down below to see how to back test each different type of instrument that you might be interested in trading and profiting from. My name is Adrian Reed. This is Enlightened Stock Trading. I'll see you in the next video. Bye for now.