Trading Myths on the Test Bench. Here's What Our Backtest Results Say!

Transcription
Hey everyone, welcome back to this brand new video.

Since many fellow traders sometimes tell us that there are truths hidden in some trading myths, today we're going to be looking at some of the somewhat smoky and unclear issues that are part of the leading trading myths. So we'll try to shed some light on what are the main lies we're fed about our beloved trading.

Aphorisms about trading

Many novice traders often follow certain statements to the letter. However when you try to apply those statements and backtest strategies based on them, you'll see that they may not be as effective as people generally believe.

One of these statements concerns the possibility of buying the famous “dip” of a particular market. So, in other words, this statement advises us to buy when the market is going down.

But the question that comes to our mind is, by how much should the market be down? Or, is it enough to just buy and then wait? In short, let's try to clear up the situation.

"Buy the dip" is often mentioned in relation to the Bitcoin market, which we see here plotted on daily bars, and so let’s examine a simple reversal strategy on BTC to see if indeed by buying a random dip we're able to gain benefits.

And indeed, by using a simple reversal strategy that buys on the previous day's low with limit orders and sells on the previous day's high with limit orders, we'll see that we get very negative results.

Here are the strategy report and the resulting equity line. As you can see, the strategy has been consistently losing.

So let's try to add and remove a factor of 10% according to the levels considered and see if we can obtain some better results.

So, we're going to take a 10% off the level of the Low, so we just multiply it by 0.9, and we're going to add this factor to the level of the High to sell on a somewhat more well defined level.

Let's compile our strategy. So, in this case, to recap, we are going to add 10% to the value of the previous day's high and we’re going to remove 10% from the previous day's low.

After these changes, the strategy makes far fewer entries than before, but the situation changes radically because we went from an equity line that was consistently losing to an equity line that's gaining instead.

So we've just debunked the first myth of this series: you can't just claim to buy a dip in general, but you need to quantify this dip otherwise it remains an utterly misleading statement for a novice trader.

Other statements that are part of this first category of myths also have the problem whereby something isn't quantified. Let's look at some another examples. Take the "never try to catch a falling knife" statement. Also in this case, the "falling knife" isn't quantified. And the same applies to the "buy low and sell high," statement, where we're not told how high or how low. Or again in the statement "trend is your friend"… I mean, come on, this may even be true in some cases, but how do I take advantage of the trend? How do I understand whether the current trend is bullish or bearish?

Unfortunately, these trading phrases can't help us with this. So, there's a need for rules and critical sense to establish the validity of an idea and not for general aphorisms such as these ones.

In systematic trading, on the other hand, you can quantify everything because you have to precisely evaluate every statement, every single idea that you'd like to translate into code, and then backtest it clearly on the past to evaluate its possible benefits.

Conspiracy Theories

But let's move on now with our review, talking about the conspiracy theories that many traders unfortunately believe. In particular, I often hear "stop-loss hunting," somewhat as if for some mysterious reason the broker or another trader was waging war, financially speaking, on us little fish, retail traders, who are on the other side of the world.

In short, a theory that the market has it in for us in some way, and therefore we believe that our stop losses are seen by the market, which does everything in its power to make us execute them and drive us out of the market.

Now I'll let you in on a secret in case you weren't aware of it: even having the ability, as is the case with institutions and banks, to have access to all levels of the book of a given market, stop type orders wouldn't be visible to these market players.

Simply put, no one in the world, other than the brokers themselves, who must be trusted willy-nilly, can see where you've set your stop loss. So, this rules out the possibility that anyone could somehow have any influence on our stop orders.

In trading, unfortunately, we will win and we will lose, but that isn't why we should blame the market. Probably our strategy had some shortcomings.

This is also reflected in the fact that, if we think about it, not only retail traders are the ones who lose. On the contrary, often prominent figures like Bill Ackman, whom we see here in this article, make the headlines for their big losses.

An example? Bill Ackman, the manager of Pershing Square, one of the most renowned and largest funds for Asset Under Management, a few months ago had to close his position on Netflix, a position worth hundreds of millions of dollars, if not a billion, and he recorded a loss of $400 million or -35% for Pershing Square.

In short, in the world of trading, no one is exempt from losses, least of all a novice trader who bases his trading on a plan that lacks details.

Trading is easy

Another cliché, the third one we're going to see together today, and one which is often advertised also by brokers around the world, is that trading is simple and accessible to everyone. So accessible that one can even trade from the beach, perhaps lying in a hammock with a cell phone in one hand and a mojito in the other.

As I hope you are well aware, this is a completely misleading stereotype. Trading is a subject that requires in-depth study to become independent and profitable in the long run. And I certainly have a hard time thinking that any profitable traders trade, say on DAX, from under an umbrella at the beach.

Can you get rich quickly?

Similarly, it's also really very difficult to think that you can get rich quickly by trading… Something like, I'll start from $10,000 to get to $1,000,000 in a year… That's hard to believe because that would assume a very high risk per trade. As, for example, was the case of Larry Williams, who in 1987, clinched the World Cup Trading Championships, making a record performance of over 10,000%.

And yes, this is the same championships that our Andrea Unger has won 4 times, the only person in the world!

In that case, Larry Williams used a very aggressive money management model called “Percent f”, which at times caused him to risk as much as 20% or 30% per trade. In short, something that is difficult to replicate outside of a competition like a world championship.

The Holy Grail

Another false myth concerning trading is to think that there is some strategy or indicator that can consistently make money every day of the year. A kind of Holy Grail of trading, impossible to find but certainly sought after by many.

This is simply a lie since, as mentioned earlier, there is no foolproof strategy that sometimes doesn't involve losses or risks. Losses in trading could be likened to the costs faced by a business, so the costs that are part of the business plan of that particular entity.

So be wary, mind you, of those who try to suggest that you buy their services if these same services they offer are presented as totally foolproof. The scam in this case may indeed be just around the corner.

The more complex the better

There’s also a tendency to believe that the more complex a strategy or indicator is, the more luck we'll have in our trades. This, too, isn't always true. On the contrary, adding more and more conditions on top of conditions to an already filtered strategy could lead to what we call "overfitting," which is an overuse of filters and conditions that would inevitably lead us to lose money in out of sample, namely when we go live with our strategy.

Percent Profitability

Finally, the 5th and last false myth we'll look at today is about the profitability percentage of a strategy. Sometimes there's a tendency to believe that if a strategy has a low profitability percentage, meaning that the ratio of profitable trades to total trades is less than the number of the losing trades, then that strategy will definitely be a loser. So when you lose more times than you gain. But is this true? Or does it depend on the type of strategy we're using?

Let's take a look at a chart that helps to exemplify this calculation. For example, with 20% you would need to get to at least a risk to reward of 8:1 and so on until you get to perhaps having 90% of open positions in profit, and in this case, it would be enough to even have a risk-reward slightly above 1.

Example strategies with different % profitability

Here we have three strategies on the Gold futures market, all three slightly different, as we’ll have one strategy with a high percentage of profitability, a second strategy that's more balanced, so with a ratio between profitable and losing trades around 50%, and then a trend-following strategy that instead will have a profitability percentage of less than 50%, so there will be a majority of losing trades compared to profitable ones.

In general, trend-following strategies tend to have a low profitability percentage. Here, let's look at the trend-following strategy. This is the equity line of the system. And what we're interested in seeing right now is, as mentioned, the ratio of the average win to average loss, which is positive, so greater than 1 in this case, because the profitability ratio of this strategy is less than 50%.

Here, as mentioned, this kind of strategy, while having a low profitability rate of around 44%, definitely succeeds in making very good profits.

Let's turn to a reversal-type strategy that has a very high profitability rate indeed. Why is this? Because it features a very close take profit of $600. $600 which by the way is very little in the Gold market, just think that it's equivalent to only 6 points.

And here I'll be much more likely to close out my trades in profit rather than at a loss. But why? Well, because the take profit is smaller in value than the stop loss, so statistically I'll be much more likely to get a take profit instead of a stop loss, which instead is larger, at around $1,300.

So, in this case, we’ll see a very high percentage of profitability, almost 70%, but a negative average win/average loss ratio, so less than 1. The times we gain, we'll gain less than the times we lose.

Finally, let's look at this strategy, which instead has a percent profitable around 50%. So, as I said, it's more balanced. The average win/average loss ratio is positive, but only slightly.

This equity line also works, so all this is to say that generally, trend-following strategies tend to have a low percentage of profitable trades. Consequently, in these cases, we'd be looking at a positive win/loss ratio, namely the average gain will be greater than the average loss. Whereas, on the other hand, on a bias or reversal strategy, which both tend to be more consistent, having a risk-reward ratio close to 1 or even below 1 as we saw for the previous strategy.

So, again, it isn’t true that a strategy with low profitability is bound to lose. It will simply do so with less constancy. If it's to gain it will gain with less consistency, as it would be too much to ask a market to breakout every day of the week.

So if there is anyone among you who is interested in the world of systematic trading, I suggest that you go and click on the link in the description of this video. You will be able to watch a free presentation by Andrea Unger or hey, go and book a free call with a member of our team, and also go and get our best-selling book too by just covering the shipping costs.

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Thank you so much for watching! I will see you soon in our next video, bye-bye!

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Trading Myths on the Test Bench. Here's What Our Backtest Results Say!

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