In part one of this series we have discussed the topic of whether to react to market conditions as they unfold , trading the market without judging its move, just waiting for the market to confirm if it is going up, down or sideways and only then make a move, with respect to forecasting market moves , making a trading decision before the market makes its move up, down or sideways, so basically it comes down to whether a trader should analyze the market and make a move before the market moves or after it had already moved and confirmed the analysis.
We will examine the two approaches to trading by backtesting two trading strategies that implement trading rules for reacting and for forecasting, the backtesting results are displayed in this article for you to decide which of the two methods for trading better suits you as a trader.
Backtesting a trading strategy that reacts to market moves
This trading strategy is reacting to the market, it waits for the market to make a move up, down or sideways and only then decides to enter a full position, it exists the trade when the market makes a move in the other direction, this way the market leads and the trader follows
| Test period | 24/04/2017 – 21/04/2020 |
| Expectancy | 0.94 |
| Percent Profit/Loss, CAGR | 16.88%, 4.54% |
| Max DD | 11,419.65$, (9.29%) |
This image displays the equity curve after backtesting the trading strategy, the equity curve is following the market, for the most part , it does not start uptrends as soon as the market starts to climb and it corrects with the market down to a certain point and no further, when the market falls heavily it’s out protecting the trader but it does not take advantage of the immediate bounce back, waiting for the market to be sure it is on an uptrend.
Regarding drawdowns, the strategy has a maximum drawdown of 9.29% in the last 3 years and that includes the time periods when the market fell -20% in October 2018 and the -35% meltdown we had recently.
Backtesting a trading strategy that forecasts market moves
Now moving over to backtesting a trading strategy that forecasts market moves, it does not wait for the market to make the move, it anticipates the move before the market moves and again forecasts the exit and closes the trade, the forecast is based on oversold and support levels for the entry and overbought and resistance levels for the exit.
| Test period | 24/04/2017 – 21/04/2020 |
| Expectancy | 5.06 |
| Percent Profit/Loss, CAGR | 4.55%, 1.20% |
| Max DD | 33,066.00$, (27.98%) |
As you can see the strategy is trying to forecast the next move of the market based on the entry and exit conditions when it gets it right it is up with the market but sometimes it gets the entry wong missing a good opportunity to follow the market up when trading these types of trading strategies , it comes down to the hit rate of the trading strategy, in case you have a trading strategy that gets it right more than 50% and a positive expectancy, you will have a good pnl.
In our case, this trading strategy backtesting results show a 65% winning rate.
The drawdown picture validates what we have discussed so far
Close to 28% drawdown in this trading strategy in the past 3 years, less than the market but more than the previous trading strategy we have backtested.
To conclude
The trading strategies we have backtested are a simple example to show the case for and against following the market or forecasting the next move of it,
Trade smartly,
Alon