Testing Trading Methods

Binary Options Testing 101

testing101Welcome to the wonderful world of binary options trading. It is an exciting, fast-paced world, but have you taken the time to slow down and test your trading strategies before going live? Newbie traders frequently are so eager to get started that they end up skipping this critical step in the process. What happens when you decide to go straight from the drawing board to a live trading situation with real money? The result is the same every time: You will lose money sooner or later, and probably all of it. Binary options trading only comes with the option of long-term success for those who are willing to invest in it. That means more than just investing your money. It also means investing your time and energy into the learning process.

STOP! Read our Beginner Tips before you set up a trading method

Hopefully by this point in time you have read up on money management and trading strategies. If you do not already have a trading method and a trading plan, you will want to start formulating those first. A trading plan covers all aspects of your trading, including your method, your plan for money management, the days and times you will trade, and how you will track your progress and grow as a trader. A trading method or system is a set of rules for actually placing and closing trades. A method may be based on technical indicators, price patterns, fundamental analysis, or some other form of study.

Anything can look good on the drawing board. As a new trader, you may think that trading is very intuitive. Intuition certainly plays a role in trading for many traders, but it should not be the sole and exclusive basis for your trades. You should never mistake theory for practice, and believe you are an expert at the latter because you are an expert at the former. If you understand why a given trading method works (or should work), that is excellent. It will help you to stay profitable over the long run. But remember, not everything that works in theory translates to the real world, and that is why you have to test.

Testing actually has two roles. The first role is to test your trading method. You get to find out whether your method actually would have worked in the past and whether it is likely to work in current conditions without risking real money. The second role is to test yourself. You get to discover what kind of trader you are, how your emotions and skills impact your own trading, and whether the system you have chosen is right for your trading personality. You may think you know everything you can about yourself, but as you will discover by testing, learning about your trading personality is itself a long and often surprising journey of discovery.

There is no excuse to not test out a demo account! Learn why

Backtesting

The first type of testing you will probably do is backtesting. This refers to testing your trading system on historical data. You are going to need to get set up with charting software to do this. I recommend MetaTrader 4 or a similar platform which allows you to view detailed charts, look at any timeframe you want, customize the appearance of your charts, and place useful indicators which allow you to see what is going on in the market. How you set up your charts will depend on what your trading system calls for. A fundamental analysis trader might have a couple of indicators for context, but otherwise may not need any more guidance on paper. A technical analysis trader might have just a couple of indicators or a lot of indicators, depending on the system. A price action trader may also have some indicators for guidance (or not).

Save your chart setup as a template so that you can easily overlay all your settings and options onto any new chart you open. That way you don’t have to manually set up every time you want to view a new asset or time period. This will save a lot of time as you do your testing.

How does it work? Simply scroll back in time to an earlier date, and then look at the far right-hand side of your chart. Imagine that you have traveled back in time, and the last bar you see on the right-hand side is the last bar that has formed, and there is nothing beyond it. Next, step the chart forward one bar at a time, and look at each bar as it “forms.”

When you see a trade setup (as defined by your trading rules), record an entry if you would take one in real life. Note down the expiry time you would accept (sadly this is variable in real life and will reduce the accuracy of your testing, unless you use Option Builder to customize your expiry time; some brokers offer this, while others do not). Step the chart forward one bar at a time, and imagine you are in the trade. Close out early if you would in real life, and do not if you wouldn’t. Record the honest result of the trade as it comes to a close. Would you have won or lost?

You should do enough of these that you can establish firm patterns and easily calculate statistical information about win percentages, the sizes of your wins and losses, and more. I recommend that you record your wins and losses in a spreadsheet and then have the spreadsheet calculate these statistics for you as you go. That way you can track your progress on an ongoing basis, take notes, modify things as you need to, and work to improve your progress. If a system is not performing at all up to your expectations, you can scrap it and move onto another one. If you are getting good results, you can work on identifying ways to make the system perform even better. How many backtest trades is enough? That depends on the trader to some extent, but I suggest doing at least 50. A couple hundred is even better. This will not take you that long once you get into a rhythm. You may need to do quite a few backtests to find a profitable system, but look at it this way: Can you imagine how much money you would have lost if you had skipped this phase? As you go, you will be able to calculate that number, and odds are that will be enough all on its own to convince you to keep going until you are profitable on paper.

Use these 6 Helpful Statistics for trading

Demo Testing

Demo testing is another key step in becoming a successful trader. What is demo testing? This is where you take a system which tested well on historical data and start testing it in real time online without investing real money. You can read about it in more depth in our article on the subject, where we also introduce you to various binary options brokers that have a strong reputation and offer a demo account to new traders.

When you open a demo account, you will be given a set amount of virtual “currency” with which to trade. You will get to use the exact same interface as you would for trading with real money, but without the risk. You will enter and exit trades in the exact same way that you would if you were trading with real money, and the result will be accurately recorded in your virtual account balance. For new traders, this can be a sobering experience.

Why is it important to demo test? In short, you will get to find out whether your system still works in current market conditions, and also whether you will be able to trade in real time without any complications. Odds are you will actually encounter a number of complications during your testing, but it is much better to resolve these without real money on the line. Learn how to trade around a busy schedule, deal with strange market hours, and deal with the emotional ups and downs of trading without losing money. Once again, you will probably be very grateful once you start that you chose to trade on paper first, since you will likely encounter a number of hurdles and losses before you start winning consistently. Once you are winning reliably and regularly, you can progress to trading with real money—and profiting.