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Part II Testing and Evaluation Will your trading strategy be profitable? Will you survive the way it trades? The fun part of system building was just that: system building. Now comes the less interesting part: system testing. Here you analyze performance from many angles, looking for reasons to shoot your system down. After all, better now than when the market shoots you down. The next two chapters underscore this common theme: you must view system performance in light of three parameters: profitability, survivability, and psychological compatibility: 1. Can you reasonably expect your system to make an overall profit? 2. Are the risks under control, or will drawdowns wipe out your account before profits roll in? 3. Can you really trade this way, or will the stress get the best of you? A successful backtesting procedure will gready reduce the probability that you will begin trading with either an unprofitable strategy or one that does not meet your standards. It also builds up justifiable confidence in a truly good system, and after a big loss, you will need all the confidence you can muster. Chapter 8 discusses the importance of separating historical data into two or more test groups and shows an important, yet litde-known formula for obtaining a more accurate estimation of a systems expected daily profitability.
Part II Chapter 9 gives extensive coverage of numerous ways to assess system performance. The author breaks down the methods into the following categories: Profit Ratios, Return Figures, Sliding and Rolling Summaries, Equity Curve Analysis, Total Trades, Outlier Trades, Drawdown/Run-up, Consecutive Trades, and Time Analysis. Books can be written on how to analyze trading systems, but these two chapters should get you started on the right track.
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