One of the first things that people need to start their trading business is a market entry strategy, or as I like to call it your market timing system. But before you can start deploying your trading strategy, you have to test it to make sure it will give you the desired results.
Back Testing
Back testing is one option. In back testing, we utilise a software that takes the set of entry and exit criterion and applies it to a database of historic price information. The results is a simulation of what would have happened had you been running that investment system in the past.
If you have a system that utilises technical indicators, there are a number of software that can perform the test. There are also professional agencies that can run the test for you. If the system is based on fundamental analysis or is visual in nature, then you may have to necessarily get a professional agency to do it or move on to paper trading instead.
Whichever way you decide to do it, it’s important to have an idea of what results you can expect from your investment system.
Forward Testing or Paper Trading
Now, back testing gives us a preliminary proof of the kind of performance that a strategy will have. However, the data being used is still historic. Therefore, to test the relevance of the strategy in the current market scenario, we use paper trading.
Paper trading requires that we monitor the market and set up our trades and execute them as if we were trading with real capital.
This means all the details of the investment plan can now be worked out.
Taking profits for example, is always a challenging proposition. The fear of leaving money on the table or having a winning trade turn into a losing one requires us to fix a profit taking strategy beforehand.
Through the paper trading exercise, we can finalise these parameters and be ready to get started.
Starting with a Small Amount of Capital
Once you are happy with the results that your paper trading is providing, it’s time to get your toe in the water.
Fund your trading account with a small amount. The amount does not matter. But, it should be an amount that you are comfortable losing. Then, use the same set of parameters and rules that you used in your paper trading and execute in the actual market trades.
The importance of this step is to make sure that the market dynamics are taken into account.
For example, I had been using options strategies in the US market and wanted to apply the same in the Indian market. But I soon realised that the options market for most scripts in the Indian market, at the time, was illiquid. That is, the volume being traded was very small.
So a very successful strategy in one market turned out to be not so successful in another.
Going Live with Full Capital
Once all the wrinkles have been ironed out in your investment plan, it’s time to make some serious money.
This can be a very trying experience.
But if you have done your planning well, this step should go quite smoothly. The important thing to remember here is that the rules and process should not change.
What you have tried, tested and confirmed in the previous should continue here.
