As mentioned in my earlier post, there is no one good trading system that suits all traders. Even if all traders adopt the same trading system, they might experience different profits and perhaps even different success rates.

Mainly because a large part of trading is still human, our emotions, our fear and greed etc. There also isn’t THE ULTIMATE trading system that is suitable for all market conditions. The market is always changing and evolving.

Ok, now that I am going to share the trading systems that are available from the Internet in my future posts, shared by the generous traders out there. What should you do with them? The following are the classic techniques, and the most reliable of all, to tell if a trading system is suitable for you. Before you take the plunge and face the wrath of the market.

Backtesting

Investopedia offers a good article on backtesting. Simply put, is to test the trading system with historical stock price data. It is like, you travel back in time and see if you were to apply the trading system, how will the results be like? The good thing about backtesting is, you will be able to know the results instantly because everything has passed and the outcome is already known. Unlike in paper trading which will be discussed below.

Finding historical stock quotes is simpler. Yahoo! Finance provides a very good tool to find historical stock opening, closing, high and low prices for the date period specified. It even has information about the daily trading volume. This example is for Apple (AAPL). The best part is you can even download the data as a spreadsheet to work off your Excel. For the techie, you can message, manipulate and format the data to the way you like it to be presented using Excel macro programming (as introduced by SimplyOptionsTrading). This is the primitive (quite laborious as well) way of backtesting.

Then there are backtesting softwares available, such as the AmiBroker. I have not tried these backtesting softwares before as they usually come with a hefty price tag. I am doing fine with Excel currently

Finding historical Option quotes is more tricky. Firstly, I have not come across websites that offer historical Option quotes for free so far. Optionpricehistory.com is one website that offers historical Option quotes (with a fee). Secondly, you must be ready to handle the huge amount of Option quotes data. For a particular stock price at a particular time, there are multiple strikes prices to look at as well as there are multiple Option expiry months to look at. So you have got to know what you want, if not, you will be overwhelmed by the large amount of data. I recommend you also consider the amount of effort needed to process the data and whether is it worthwhile doing.

But just like to share this particular online application that I came across (courtesy of Greeksman) known as Platinum (from Optionetics). There is this particular backtesting feature that I feel will be useful. From the online Flash demo, click on “Setting up for Backtesting” to check it out! By selecting the date in time we want to move back to, the entire platform “goes back in time” and all the stock and Option prices will be those at that point in time. If only my online brokerage can do this as well

Paper Trading

When we paper-trade, we are just trading with paper-money ie, fake money. Some call it virtual trading. So we are trying to simulate trading by using fake money. The difference from backtesting is that instead of using historical data, we are using live data - live stock quotes, Options quotes etc. And we have to wait for the stock prices to actually move before we can know the outcome of our trade. Both the online brokerages (OptionXpress and Interactive Brokers) that I am using provide paper trading platform that are almost exactly the same as the actual trading platform. So I can experience the actual trading process with the actual trading tool but with fake money.

When to use which?

You should subject a trading system to both! Before you start thinking of using real money with any trading system. Personally, I feel that each technique has their own strengths and weaknesses.

Backtesting is more suited for more technical testing. For instance, we could use it to test if a particular indicator, oscillator, chart pattern or candlestick formation that a trading system uses for trade entry is reliable.

Paper trading is more suited for familiarizing with the trading platform, your reflexes for trade entry, exit and stop (if they are manual), the mechanisms for trade entry, exit and stop (if the trading platform provides automation).

There are some aspects of trading that is not addressed by these techniques. That is your emotions, your fear and greed that comes into play when REAL money is involved in the trade. This is where good portfolio/money management rules come into play. Good portfolio/money management rules helps to ensure survivability in the market, that we are not knock out (KO) by the market with a single trade and be able to stay in the game always.

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