Have You Ever Tested Your Trading Beliefs… Or Just Assumed They’re Right

How does backtesting improve our beliefs about trading? This is a little bit subtle. What do you believe about the market? If you really just sit and think for a moment, you've probably got some beliefs about the market. Oh, this happens when you buy a stock. You should do this. When you buy a stop, you should have a stop loss. Yeah. Some people say yes. Some people say, what's a stop loss? Some people say, not always. Some people say, no, I never have a stop loss. So people have different beliefs. Now, I used to believe that you should always have a stop loss. That was a rock solid belief. I had an in market stop on every single trade. But now that I can back test properly, I can test that belief. All right, I've got a system. It has a stop loss. What happens if I take the stop loss out? What happens if I widen the stop? What happens if I narrow the stop? What happens if my stop isn't in market? It's next bar on open. And you can start to investigate your beliefs and see if they're actually true. And I've got a really great example of this. I have a system for Hong Kong stocks. I've traded for a long time, many years. It's probably my favorite system, if not one of my favorite systems. Not that we should have favorites. We should be completely unemotional. But I am human, so I have favorites. Anyway, so this system had a in market stop loss. I was like, Hong Kong market is really volatile. My stop keeps getting hit. And I feel like maybe I shouldn't have an in market stop. I wonder if it's really true. And so instead of having an in market stop, I back tested the same system with a next bar on open stop. Now an in market stop. What's the problem? The stop loss is here, the price is up here. But there's a sudden panic. The price dips down, hits your stop loss, you get out and then the price does what? Boink. Bounces straight back up. Now the discretionary trader who lacks the discipline to follow the rules will say, I see, I shouldn't have a stop loss. And so they stop putting a stop loss in the market. And then what happens? As soon as you do that, the market goes down. And it keeps going down. It keeps going down. And you're like, oh crap, when should I get out? This loss is now too big to take. I'm panicking, frozen during the headlights. So from a discretionary trader's perspective, that's really bad financially. But systematically, I can test different types of exits. So I tested Instead of getting out in market, I tested next bar and open. It gave a 40% improvement in expectancy just by making that one change. Exiting next bar and open instead of exiting in market. Why? Because the market was so volatile that the long weeks kept hitting the stop loss. But it was closing in that day and then opening next day way up from where the stop loss was. So the excess emotion, the fear in the markets intraday was causing the system losses that were necessary as long as I had the discipline to exit the next bar at the open. If the stop was touched. I'll get out here. There was almost always a bounce. Not every time, but on average over many trades there was a bounce. And so on average, my, my average profit per trade went up, expectancy went up just by making that one change. And I would never have done it if I couldn't have back tested those two different rules and compared them. So my belief that every trade should have an in market stop loss, I proved wrong. Now I have plenty of systems that don't have a stop loss or have an in market stop loss or a next bar and open stop loss, I don't care, as long as it's best for the system. You've probably got some other beliefs, so what I'd encourage you to think about, what are they? What beliefs do you have that you should do? And if you haven't tested those to validate they're actually true, maybe it's time to just like the stop loss thing, what are some other beliefs? Only go long in a bull market. Never go long in a bear market. Always have a risk return ratio of 2 to 1 or 3 to 1 or 4 to 1. Whatever your belief is, once you've got a certain amount of profit, move your stop up to break even so the profit can't turn into a loss. These are all beliefs that people have and almost all of those are wrong in certain situations. They might be right in other situations, but they're not always right. And so here's the next lesson in our trading. We need to revalidate our assumptions every time on every strategy in every market. Because different markets behave differently, different strategies behave differently. What you do with mean reversion is different to what you should do with trend following.