I like to have an estimate for how much pain (drawdown from equity peak) I should expect to undergo in pursuit of how much gain (net profit) over the course of trading for, say, a year. If I then encounter a significantly worse drawdown in actual trading, then I know that there's something wrong somewhere - either the market may have changed, or the tradable may have changed, or I'm not executing appropriately, or some other calculation or expectation was wrong.
I also want to know what's going to happen if I just happen to start trading my system at what would have been a peak, and if I'm therefore going to start out at a significant disadvantage. Experience has shown me that there's something about trading, analysis, and testing that increases the likelihood of this occurring: There's not a poor chance that whatever new market perception or analysis has led you to re-tool is based on some relatively extreme or at least extraordinary set of conditions that are likely, for a time, to regress or revert to or toward some other mean. When the market is collapsing, both your mind and your data are likely to become more open to enhanced short-selling tactics. When it's in a range, you focus on countertrend trading, and so on. By the time you've worked out how you might have traded that period most effectively, you're suddenly in the middle of a big counter-move or breakaway or whatever. It takes an act of will to think hard about and to research trend-trading tactics amidst a range-bound market, and vice versa.
I've also found, by the way, that the long-side bias in equity trading still seems to show through. Part of it also has to do with the role of gaps and counter-trend trading. In any event, under diverse strategies and even in stocks that have fallen 80% or more over the last year, it can still be as easy or even easier to accumulate profitable long-side day-trading testing results as short-side ones.
Even using a very long time frame such as 20 years doesn't save you from such a problem: The last 20 years have been, after all, a major bull market in the S&Ps. |
