Trading Lesson of the Week

Check back weekly for another free trading lesson:

Effective Strategy Testing

In This Week’s Issue:

  • Stockscores’ Market Minutes Video – Be Patient for Proof
  • Stockscores Trader Training – Effective Strategy Testing
  • Stock Features of the Week – Abnormal Breaks

 

Stockscores Market Minutes – Be Patient for Proof

Traders often get out of trades too early because they don't see the proof that they are right. Take time and stick with the trade until there is proof that you are wrong. That plus my weekly market analysis and the trade of the week on SRRA. Click here to watch on Youtube

To get instant updates when I upload a new video, subscribe to the  Stockscores YouTube Channel

 

Trader Training – Effective Strategy Testing

We have all heard the story about the King who asks a group of blind men to feel an elephant and report back on what an elephant is. Each feels a different part and as a result, each has a very different perception of what the elephant is. They fail to accurately understand the Elephant because each does not touch the entire animal.

Many traders fall in to a similar mistake when evaluating their approach to the market. It is very easy to misjudge the effectiveness of trading rules by looking at the result of the last trade. If you buy a stock because it is breaking to new highs and the trade ends up failing, it is easy to say that buying stocks breaking to new highs is not an effective strategy.

This concept is referred to by some as being fooled by randomness. By drawing conclusions from a small sample of data, the trader makes an incorrect assessment of cause and effect.

To really judge the effectiveness of strategy rules requires they be tested over a large sample size, at least 30 trades but more is better. Only then can you start to see patterns and correlations. Only then can you assess cause and effect.

Suppose you are sitting in front of your computer and you decide that you will buy shares in Herbalife (HLF) if the next car that drives past your window is blue. The next car that drives by is blue so you buy HLF and the trade ends up making you a $1000 profit.

Encouraged by your result, you take a look at Pfizer (PFE) and again determine that you will buy the stock if the next car that drives past your window is blue. The next car surprises you by being blue so you buy and again, you make a profit. Trading seems easy!

What do you think would happen if you carried out this rule for your next 30 trades? Since most will realize that there can be no cause and effect between a blue car and a winning trade, most will say that the overall result should not be positive. Intuitively, you know what there can be no correlation between the color of the car that drives past your window and the performance of your trades.

However, what if your test actually finds that 25 out of the 30 trades you do end up being winners? Is there now reason to believe that blue cars predict strong stocks?

The problem is that even when there seems to be a correlation between one factor and a result, it could simply be that there is another cause at work. The reason that there was 25 winners out of 30 could simply be due to a strong trending market that makes most stocks rise.

This example highlights two important considerations when assessing the effectiveness of strategy rules.

First, make sure you test a rule over a large sample to get data that is reliable.

Second, test your strategy rules over varying market conditions so you can remove bias.

When testing the rules of a strategy, do not stop at the entry rules. Evaluate the exit strategy and how you size positions and do risk management. Small changes in any of these areas can have dramatic effect on your profitability. I recently completed a two week test of one of my day trading strategies and found that a couple of minor changes to the exit strategy more than doubled the profitability of the strategy during the test period.

If you want to truly understand how well your trading strategy works, take the time to compile data on a large number of trades across varying market conditions. Avoid looking at just one factor or the results of your last trade.

Get the weekly email from Stockscores founder Tyler Bollhorn

Get our weekly trading lesson and stock trading ideas direct to your email in box with the Stockscores Foundation newsletter.

Learn how to be a better investor and trader plus see how to best utilize the tools of Stockscores.com.

This is a free service from Stockscores with no spam (we hate spam!). Enter your email address below to register for future email editions and see the archive of past newsletters.

Past Trading Lessons

June 18, 2018Effective Strategy TestingT.NEPT | BLPH | CLSN
June 18, 2018Effective Strategy TestingT.NEPT | BLPH | CLSN
June 10, 2018Trade With Fact or Fear?APRI | BLCM
June 3, 20187 Important Trading TechniquesSTNG | GIGM
May 28, 2018The Expected Value of the TradeSVRA
May 20, 20188 Mistakes of the HeartASNA | CTIC
May 13, 2018Stop Fear in Your Trade Decision MakingT.AUP | T.WEED | TYME
May 6, 2018Trading Should Not Be GamblingCRNT | BPY
April 29, 201815 Core Trading Principles
April 22, 2018How to Measure Your Trading Performance
April 15, 2018Do You Gamble or Trade?T.MOGO | ZIXI
April 9, 201810 Ways to be a Better InvestorHAL | XOM
April 2, 2018Be the Fussy TraderT.HXD | VXX | SDS
March 25, 2018How to Be a Better TraderV.GENE | V.HEMP
March 18, 2018Trade Stocks for a Living - What You NeedNFEC | RKDA | AMTX
March 11, 2018Don't Be a Reckless TraderVVUS | YRD
March 4, 2018Seven Ways to Take Emotion Out of TradingV.PQE | ARLZ | UPLD
February 25, 2018Trading Success with StatisticsACHN | T.THO
February 18, 201810 Ways to be a Better InvestorSTKS | CTG
February 12, 2018Never Fall In Love, Is the Stock Market Crash Over?AQMS | UAA
February 4, 2018Here are 7 Reasons to Say No to the TradeVXX
January 28, 2018Does Size Matter?VXX
January 21, 20183 Ways to Improve Your Trading ProfitsLTRX | NVCN
January 7, 2018Trade Less, Make MoreHEB | NIHD | V.SLL
December 23, 20178 Trading Resolutions for 2018
December 10, 2017Trading a CorrectionBUR | BCRX
December 3, 2017Strength Brings WeaknessROX | ETSY
November 26, 2017Up 27% in 4 Months, How the Big Wins Pay the ProfitsV.KALY | GLOW
November 19, 2017Overcoming FearSRAX | HIBB
November 12, 2017The Importance of Trading LessAPTO
October 30, 2017When to Say No to the TradeT.PGF | T.CPG
October 22, 2017How to Find Hot Stocks EarlyV.NGC | T.PAY
October 15, 2017How I Have Earned 33% Since AugustPLG | XNET | HRG
October 9, 2017Data Based InvestingT.SIS | BPTH | NTNX
October 1, 2017Emotion is Your EnemyCRMD | OPTT
September 24, 2017Return on CapitalT.XIU | T.XEG
September 18, 2017The Economics of TradingLLNW | DHT
September 10, 2017Money Clouds Your JudgmentATOS | GNW
September 4, 2017Key Concepts for Reading Stock ChartsT.NGD | V.GUG | ABCD
August 27, 2017Work Hard When the Market is EasyNTLA | T.AR
August 22, 2017How to Trade and Sleep Well
August 14, 2017Fear or Fact, What Drives Your Trades?
August 7, 2017Fooled by Randomness
July 24, 2017The Danger of Knowing Too Much
July 17, 2017An Important Announcement
July 10, 2017How to Measure Trading Success
June 26, 2017Fussy Traders Make More
June 19, 2017Stop Trading Sense
June 12, 2017NoNo FOMO
June 5, 20178 Emotional Trading Mistakes