A good trading strategy helps traders to earn high profits. But a strategy has to be tested before you will invest big money with it. This guide will take you through this subject. I will write about the importance of testing strategies, a way of doing it and what tools you can use to optimise the process.
The importance of testing strategies
There are two main reasons why this is so important to test your strategy beforehand. First, if your strategy is not successful, you will lose your capital. Secondly, you need to recognise which strategy is winning and which is not, and without testing such a decision may be very complicated.
Testing will allow you to choose a winning strategy and to find out where you should improve. If you do not conduct testing, you can end up losing one trade after another without knowing the reason. This stops you from development. Only good testing lets you recognise what works well and what does not.
You have to look into the future. Losing 1% of your capital may not seem like a big deal. But if you keep trading with this strategy, you will ultimately end up broke. A good test helps you to catch faster a strategy that does not work and thus, it helps you to save money. You will introduce necessary changes and make the strategy work or simply change it so your trades will end with profit.
A method of testing strategies
By testing a strategy you want to get to know its winning expectancy. What is the winning expectancy? It means your average trade’s outcome in relation to your losses. Let’s take a look at an example.
You trade with a strategy that brings you 65 percent of winning trades (65 winning trades / 100 total trades = Win Ratio). If there was 100 trades in total it means that Loss Ratio = 100% – 65% = 35%.
An average winning transaction is 80 percent of the amount invested in a particular trade (it is average payout) and the average loss is 100 percent of the invested amount. We can simplify this to calculate Reward to Risk Ratio: (0.8 winner size) / (1.0 loser size) = 0.8
Expectancy ratio is calculated with the formula:
Expectancy Ratio = (Reward to Risk ratio x Win Ratio) – Loss Ratio
So in our example:
Expectancy Ratio = (0.8 x 65%) – 34% = 0.338
What is winning expectancy telling you?
You have calculated your winning expectancy. What next?
Look at the result. If it is above 0, it means the strategy is good and you can keep using it. It will most probably bring you profits.
If the winning expectancy is precisely 0, you may need to change something as it can bring you both, profits and losses.
If, however, the result of your calculations is below 0, you definitely have to change something in the strategy you are using. Otherwise, you risk losing money.
Winning expectancy calculations give information about the probability of winning for you only. The traders differ significantly. So it is not a good idea to compare the result of the same strategy with others. One strategy may work for one trader well, but another will waste money with the very same one. It is because we have different preferences, different styles. Some functions best in the mornings, other in the night. Some choose to open long positions, other short ones.
The conclusion is that you should test your strategy alone and find out what is your individual winning expectancy.
The steps to take to test a strategy
Testing should be based on many trades. The result will not be credible if you consider just 10 trades. You have to use at least 50. The more the better.
What steps do you have to take to test a strategy?
- Use the same strategy for some time.
- Write the details about every transaction, whether you win or lose and what was the return.
- Estimate what is your winning percentage that is how many trades won.
- Determine what is the average return per winning trade.
- Estimate the winning expectancy.
- Analyse the result. If it is above 0, keep trading with this strategy. If it is below 0, introduce changes and repeat the steps until you receive a higher value than 0.
An Excel file can significantly simplify and fasten the calculations. Also, collect your notes so you can view them in the future and choose the right strategy.
What kind of tools can optimise testing?
Olymp Trade offers a free demo account and this is the best tool to use when testing a strategy. This account is implemented with demo currency, nevertheless, you have access to all other features and indicators available in the real one. So you can test a strategy without risking you lose your own money.
This tool is perfect not only for beginners. More experienced traders can also use it to play with different variations of their strategies and to find out if the modifications improve the winning expectancy.
Using a demo account makes it easy to check whether a strategy is good or not. It is enough when you check the account balance. You had $10,000 at the start and now you have $5,000. This shows you that something does not work. Though, if you have $15,000 in the account, it signifies a strategy is good.
Olymp Trade demo account
You can open an Olymp Trade demo account completely free. You will receive 10,000 demo currency at the beginning. Your investment can start from just $1 per trade. You get access to all the features available on the live account. When you lose money or your account balance drops you can replenish it.
I believe you do understand now why testing strategies is so important. It saves you money and helps to discover a winning strategy. Especially, that with the Olymp Trade demo account, your testing is completely free.
Once you find a winning strategy, you should not stop testing it. Keep making notes as mistakes happen to everyone. With ongoing testing, you will catch them quickly and will be able to come back fast on the right track.
I encourage you to share your thoughts about testing strategies in the comments section below.
Wish you high winnings!
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