TRADETHINK ARTICLES

The Importance of Trade Validation

October 28, 2009

By Chris Morse

A trading system can be a wonderful tool when it comes to catching moves in the markets. There are many trading systems available to traders. Some methods focus on day trading while others will focus on trend trading. Many systems take an approach to a specific market or sector while other systems can watch many different markets across the board. If you are a trader and looking to profit consistently from movements in the markets you will need at minimum a disciplined trading approach and a way to identify which markets to trade, whether you are looking to position or day trade, a method for deciding when and where to enter a trade, a method for deciding when and where to exit a trade, and whether you want to go long or short the market.

How does one best go about selecting a trading method or system? It is important to find an approach to the markets that has been validated and tested. You want to be able to confirm real-time trading results along with longevity of the trading method. Too many trading systems come and go every year. Most systems or methods look great on paper and in testing (whether this is your own conception or someone else's) only to find out they don't work as prescribed in the real world.

The bottom line is a trading system or method must be validated to trade it with any confidence. How do you validate a trading system? You will want to see actual trading system results, entry points, exit points and trade by trade results going back as far as the system inception. Note: If a trading system has been adjusted or modified, I suggest that the system is only valid to the time of the modification. So, if a system has been around for 10 years, but has made changes along the way, the system is only good to its most recent change. It is also nice to see how a system has performed in times previous to its inception. You can use back testing to validate a trading method as far back as data will allow. I personally test my systems 25 years back! If you develop a trading system that looks great going back 1, 2 or 3 years and the systems can't hold up in the prior years, then you probably do not have a system that will hold up in the future. A system must be able to withstand the test of time.

To get true system validation you will want to investigate several aspects of the system. First, when was the system originally developed and have there been any changes, if there have been any changes you will want to be able to see a side by side comparison of the system pre and post change (if the system before the change is no longer working then how can you expect the system to work after the change). Second, you will need to see equity curves for the system since inception and preferably as far back in testing as possible (I can take my systems back 25 years or more). Third, you need to verify past trade by trade results, this means that if the system follows X number of markets then you will want to see the results (or at least have access to the results) for all of the markets, not just the ones that are doing well at that time. Fourth, when a system follows multiple markets you will want to be able to see portfolio reports on the entire system (basically the sum of all of the markets being traded). And if you really want proof that a system is as depicted, look to see if there are multiple sources of portfolio performance results. A developer should be able to show you results on his proprietary platform, TradeStation, Excel and 3rd party portfolio validation testing programs such as Rina Systems or Portfolio Merge. All this data is available to the developer if he is legit. Note: Though all of this data is available to developers and individuals creating and using trading systems, it can be time consuming to put together this information for review. As a professional courtesy, please only inquire for information request from anyone if you have a sincere interest in using their trading methods (this means purchasing) and not for just curious research. Don't take the developers word for it! Any developer with his salt will also have clients and brokers that he/she has worked with for years and years. If the system is as claimed, then someone will undoubtedly still be working with the system whether it is a client, a broker or both.

I will show you what I mean by system validation. Here is a system I developed nearly eight years ago. The system has never had a change and can be back tested to twenty-five plus years with great success. The portfolio below follows ten diversified markets. Currently the system is in 6 trades out of 10. Here is every trade (winners and losers). The charts are from TradeStation to prove and validate the trading system signals are legitimate.

THINK MT Open Positions: $24,962.50

Copper - Most recent entry on 10/21 for $300.00 profit.

Dollar Index - Most recent entry on 7/15 for $3,620.00 profit.

Euro Currency - Most recent entry on 5/20 for $14,412.50 profit.

London Gas Oil - Most recent entry on 10/12 for $4,150.00 profit.

Palladium - Most recent entry on 10/06 for $2,455.00 profit.

Soybeans - Most recent entry on 10/12 for $25 profit.

As a trader and developer I cannot emphasize enough the importance of validating trades and trading signals for a trading system. If something looks good on paper, please don't hesitate to do you due diligence on the trading system or method. Trading system validation is just as important whether it is a system you developed from scratch or if you are an investor and are investigating the merits of purchasing a trading system.

About the Author

Chris Morse is the Developer of the TradeThink trading system. He has been involved in the development of trading strategies for nearly ten years. Mr. Morse developed a very robust system which is now in private use at one of the largest FCM's and has earned sizable returns for the last 3 years. Mr. Morse now focuses his time exclusively on developing and managing his systems.