CFD Trading Systems: Tips On Backtesting A Mechanical Trading System For CFDs

With making money with CFD trading (contracts for difference), because leverage is involved, a good system or strategy for CFDs, to trade CFDs properly is even more important.

A CFD trading strategy serves to give an indication of how a system has performed over the past, and hence gives an indication of its possible performance in the future.

We will never have 100% prediction of future performance, and we never will, but backtesting whether it’s manual or with trading software such as MetaStock, TradeSim, Trade Station, WealthLab, Amibroker or other trading backtesting software will give us a lot of information.

There are weaknesses of backtesting results that you should be aware of.

So when we're talking about a backtested trading system, we are referring to a "mechanical trading system".

It gives a very good idea of whether a CFD system is even profitable or not, how profitable, how consistent, and a host of other parameters that are available when you backtest a system.

This is crucial in the process of a system trader.

What’s a CFD "system" trader?

A system trader trades a specific trading system.

A common type of system trading is trading with a system that has rules that are 100% mechanical. This means that the trading rules are not discretionary and can be quantified and coded into trading software in order to backtest and to evaluate how they perform.

Many traders who used to lose money in the market become profitable after applying a trading system. The trading system is one that has been shown to be profitable in backtesting. Once designed, a CFD system takes very little time to trade typically as they do not have to manually or use discretion to evaluate the market, and this avoids stress and burn out.

Their task then is to simply trade the system, and monitor the system once in a while to ensure that the system is still behaving as expected.

These are therefore the 3 principles of the mechanical system trader:

1. They want to be a system trader, rather than a discretionary trader.

2. They have a profitable trading system that they are happy with, and would like to follow.

3. They're able to follow the system.

And a fourth point: you should be able to monitor your system performance since market conditions may change making the system perform differently to the way it did in the past.

Point 2 is based on the principle that they believe that future performance will be similar to past performance of their system.

If any of these principles are not there such as not wanting to be a system trader, not having any faith in the system because they didn’t do enough work to design and backtest their system to ensure the results are satisfactory, or can’t follow a system and change the rules as they go along, then the system falls apart.

Having said this, there usually is a criteria for stopping to trade the system, if everything looks as if the system is really not performing as it should and therefore must be reviewed before trading it any longer. Some use the fact that the drawdown of a system is way larger than the historical drawdown (though it still may swing up after the drawdown is over). For example, the system may no longer suit the market if the market has changed to a significant degree.

Some people trade multiple systems to get better equity curves.

Weaknesses in backtesting CFD systems?

Backtesting has some limitations, but despite this, is a useful tool for traders.

See this page here on weaknesses of backtesting trading systems formore about the limitations of backtesting.

The main limitation is that past performance of a system is not a guarantee of future performance.

Despite these limitations, backtesting can be a helpful tool to help traders:

1. Know the performance of systems that they’re testing, including all its performance characteristics including the profitability, consistency, maximum drawdown, win loss ratios, profit loss ratios, average profit/loss per trade (expectation), etc. These are the historical performances and does not guarantee future performance.

2. Decide on which of the systems they’ve designed is the one that has the best performance in terms of profitability, drawdown, consistency and all the other performance indicators of a trading system. This will allow them to design and test many systems and choose the best one amongst them.

3. Have an ability to trade their system with more confidence as they know how the system has performed historically when tested. Of course historical performance does not guarantee future results but indicates it's typicla performace in the past.

4. Trade a system with much less time and a need to constantly think and use discretion when trading. With mechanical systems, it is about applying and following rules. It has less discretion and this can be less stressful for many people that using systems with room for interpretation or opinion.

5. Have a skill that they can take with them to use again in future. If the trader needs to design a different system in future to diversify the systems that they’re trading and to make more profits, then they can. They are adaptable, and they can create new systems when they need to (if a system stops working), or when they want to (to create another system).

If you have potential CFD brokers or providers in mind, or a range of them in mind, then consider backtesting with their available CFDs and transaction costs in mind. A system backtest should take into account the typical commissions getting in and out of trades, so the backtesting results are more accurate.

See these other articles to find out about:

The strengths and weaknesses of backtesting and what to be aware of when backtesting CFD strategies

About using Metastock and Tradesim as CFD backtesting software.


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