 Welcome back to the Trade Hacker Mindset. In this episode, I want to talk to you about the expectations of backtesting. Trading the markets can be difficult to master and seemingly just out of reach. Professional traders have a secret. Trading requires total mental and emotional control. It requires the Trade Hacker Mindset. All right, so let's jump into this topic of the expectations of backtesting. I want to kind of walk through some of the different aspects of backtesting and then talk about some of the traps that we fall into based on specific backtests. So from my perspective, the way that I use backtesting is number one, I'm using it to help create a trade plan, okay? So I'm taking the information of what happened in the past. I'm taking all the data to build out a specific trade plan that I like to trade one month at a time. So the cool thing about what a backtest does is you are, by design of a backtest, you are entering very specific criteria for a strategy and how you will manage a strategy. The cool thing is you can test it in different market environments. So you can look at how it performed when the market was in a bullish environment or when it was in a bearish environment or when we were in a high volatility, a high VIX environment, or a low volatility environment. You can test a strategy based on different position sizes. So how would it have returned if you used minimal position size? How would it have returned if you used a large position size compared to your account value? Because allocation and how you position size can make a huge difference in a strategy or a backtest. You can test just an infinite number of variations. If you're testing an iron condor strategy, for example, you can test the width between the short strikes. You can test the width between the shorts and the longs. You can test if you want to have a less width between your puts than your calls. And that's just one example of one variation of one strategy. There are literally infinite number of different variations of every strategy that you can test to determine if that is something that fits what you're trying to accomplish. You can test different profit targets or stop losses. You can scale in or scale out of a position based on a certain percentage of profit. You can exit the strategy based on a certain criteria of your exit point, your eject button, your stop loss. You can test different times of day. How does your strategy perform in the morning versus the afternoon? How does your strategy perform on Mondays versus Wednesdays versus Fridays so you can trade, so you can test different days of the week? You can test different events. So how did your strategy perform on the day that Jerome Powell comes out with the FOMC Fed announcement? How does it perform on days when the CPI data is released or any kind of event that you can think of? You can do backtest on individual stocks trying to figure out how does this stock act leading up to earnings? How does it act through earnings or after earnings or all these different variations of an individual stock? You can test how different indicators work. So when you see this ad of some guru online telling you that his magic indicator is going to give you a thousand percent return every single year guaranteed, guess what? You can now backtest that. So that's a beautiful thing. So you don't have to take anybody's word for what they tell you their performance has been or what they think their performance is going to be. You can actually see it with your own eyes and work through the data yourself. You can test how certain strategies behave based on different price action. What if the market gaps up one day or what if it gaps down one day? How is that strategy going to perform on specific scenarios like that? You get all the different metrics. What's the compound annual growth of this strategy over a specific period of time? What's the maximum drawdown that would have occurred during this time period that you're backtesting? What's the average winner? How much was the average winner versus the average loser to help determine your risk reward metrics that you're comfortable with? So all of these things that you can do with backtesting are amazing. They are an extremely, extremely valuable piece of information to help you build out your particular trading plan or your particular trading strategy. But you also have to tame your expectations around that specific backtest. What are your expectations going forward of how that strategy that you backtested will work? Because you have to remember there's a reason it's called a backtest because it is what happened backwards. It's what happened in the past. It's not necessarily what's going to happen in the future. In fact, it will never happen the exact same way in the future. There are different traders making different trading decisions that move the market going forward that were not in the market during your specific backtested period. There is a reason that in every investment article, presentation, whatever, that there's always that disclosure. Future performance is not indicative of past results or past performance is not indicative of future results. That's not just a lawyered up term, that is reality. That is realistic. That the future performance won't be the same as it was in the past. So the question is what are your expectations when you perform a backtest and you start trading it with real money? I think it was Mark Douglas in his book Trading in the Zone, one of the quotes that kind of always stuck out to me was, be rigid with your rules but flexible with your expectations. Be rigid with your rules but be flexible with your expectations. The reality is the majority of traders, especially new traders, are the exact opposite. They are rigid with their expectations. They have all kinds of high expectations of how much money they're going to make, when they're going to get their first Lambo, all that stuff. Their expectations are through the roof but they're flexible with the rules. They'll break their rules left and right and constantly be doing things outside of the realm of what they're supposed to be doing for the specific strategy that they're trading. So what are your expectations? Just because something performed one way during a specific period of time, do you have an expectation that you deserve, that you should be getting those similar type returns? I hear people quite often say, well, this never happened in the backtest. They go through a period of losing, it's usually with losing trades. This never happened in the backtest but what relevance does that really have to your trading today? The backtest is something that shows what happened in the past. It showed what happened during that specific time period that you were backtesting. Again, that doesn't mean that's what's going to happen going forward. Now, having said that, where's the line? It's a very fine line between sticking to my guns, I'm sticking to my strategy, I'm following my rules versus I'm abandoning this backtest or I'm abandoning this strategy because something has changed and it's no longer working. Where's that line? I think you need to try to determine that before you start trading it with real money. I know it's difficult and maybe it's even impossible and maybe you have to make that decision once you go through that period. Maybe there's no way around it but you have to figure out where that line is for you and it's going to be different for everybody. I've talked about before where the way that I do it is I'll take a strategy and I make sure that I test it with real money, with backtesting, with all kinds of stuff. I want to make sure that I'm comfortable trading it with specific size, with specific ways of management, all that stuff and I'll test different variations with real money after I've done an enormous amount of backtesting and then I'll determine what I want to do and I like to do that one month at a time. I usually use calendar months, so for this month of May, for example, I'm going to trade this strategy every day exactly like this and that's how I do it and so I will do that full month even if I figure out halfway through the month that I think there's a better way to do it or if I think I should change something. I'll stick with it throughout the month and then any tweaks or changes that I want to make, I'll implement those for the next month or I'll decide if I don't want to trade that. Sometimes things will perform well but I just don't like the way it makes me feel. I don't like the way it psychologically works for me and so I'll determine that one month at a time and decide if I want to continue or if I want to give it up. Last week's podcast was all about sequence of returns and sequence of losses and that plays into what we're talking about here is that if you experience a sequence of losses and it happens sooner to you in your real life trading than it did in the back test, it can be a lot bigger drawdown than what the back test showed but over time, over a lot of occurrences, is that going to work itself out so that it would have been, the strategy is just as good as the back test showed or has something changed and you need to make a change on the way that you trade that strategy. These are the questions that you have to be asking yourself and you have to do it on a non-emotional basis. One of the ways that I do it is I really dig into these trade logs of the back test and figure out okay, has this ever happened before? Are we in a completely different environment than what the back test is showing? Does it warrant changing or is this a pretty normal drawdown? Has this happened before in the drawdown? Even if it has never happened, even if it's worse than what the back test is showing, is there a logical reason for why it's happening? The other piece of this that I see a lot is when you do your back testing, you're see something where it back tests really, really well but then you get into trading it with real money and you notice pretty quickly that things aren't as realistic or the performance that you saw in the back test wasn't realistic and it could be of a small little toggle that you used in the back test. Maybe you didn't have it, maybe you had it hitting your stop loss twice before it triggered in the back test but that's not how it works in real life. If you have a market stop order and it hits your stop, you're getting out right away so that could create a discrepancy in real life trading versus the back test or maybe you forgot to add in commissions or slippage in the back test but we know in real life they're slippage. We know that we actually have to pay commissions on our trading in real life or maybe you put a stop loss in your back test that was extremely small so when you did the back testing it looked great on the back test but the reality is in real life you're getting stopped out way more than the back test shows so I mean these are all things that we have to ask ourselves that we have to dig deeper into and and that's why we're adamant in our community that that just copying somebody else's trades or just copying and starting trading off of a screenshot of somebody else's back test is ridiculous like that doesn't like that does not tell you enough information to give you that does not give you enough information to start trading a strategy with real money you have to dig deeper you have to set your expectations of what a back test is and how you should use it in your real life trading. I hope this information helps you in your testing and your trading if you have any questions you can always drop into our discord at navigationtrading.com you can get to our discord that way look forward to seeing you on the inside and we'll see you in the next episode.