Backtesting Your Futures Trading System

Once you have a system that you think will be profitable, it is critical that you take the time and effort necessary to perform thorough backtesting.Backtesting is the process of verifying that the system actually performs as expected under diverse market conditions. This ensures that you use it to trade confidently as you will know that despite the occasional loss that it is profitable over time.If you fail to backtest a trading system you will not know whether your system works and you will lack the confidence to follow your system and will begin to second guess it.Backtesting a trading system involves actually executing that system against historical market data and analysing the trades you would have made according to your system’s strategies. The easiest way to do this is to use automated trading software. All the major packages have functionality that allows you to test your system against a range of actual futures data.It is very important to test your system against an extensive period of historical data. You should not try to fine tune your system against a short period of data or you will suffer from “curve fitting”. This is when you tweak the parameters of your system, or add in extra rules to get good performance against the data set. However, if you do this, the system will perform miserably on real life data that the system is not optimised for.Not only is it important that you never skip the system backtesting process, it is also important that you spend all of the time necessary to do the job right. This can be time-consuming depending upon the complexity of the trading system you are thinking about using and the amount of historical data you will be analysing.When you thoroughly backtest your system, you will be able to determine how it performs across a range of markets: bull markets, bear markets, trending markets and range driven markets. You will need to allow for slippage (where your order is not filled at the price you want it to be filled at) and commissions.If you use a spreadsheet to test your system, make sure that you are not buying at the day’s low and selling at the high, or looking ahead into the future. Generally trading software will ensure that your system is properly tested.However, no matter how thorough, complete and accurate your backtesting strategy is, your real world results will generally slightly differ from what you expect from backtesting.When backtesting your futures trading system look for these vital indicators:Net Profit/Loss for the defined testing periodExpectancy (this should always be positive)Smoothness of equity curveMaximum drawdown (peak to trough)Win to loss ratiosAnnualised returnsRisk-adjusted returns