This column was originally published on RealMoney on Nov. 1 at 8:21 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.
What if I said that you could become a more profitable trader without changing your approach to trading? Well, you can, but sadly few people pursue one simple way of doing that, and that's backtesting.
Simply stated, if you can define your approach via a mathematical algorithm, you can test that approach against historical data to see what set of parameters would have yielded the most profit.
For example, let's say your preference is to go long any breakouts where the closing price is 3% above the previous close. You had always assumed a 5% stop and 10% target were best, but upon testing those assumptions you find out a 7% stop and 4% target are best.
Even better, a simple change like that could yield maybe a 20% increase in yearly returns.
Depending on the software, one could also test whether it's better to use hard stops or mental stops, a "time stop" (exiting after a period of time if your stop or target isn't hit), and the effect of different lot sizes. Really, any and all variables can be tested with some dramatic results coming from very slight changes.
There is a variety of software out there to pursue, notably: www.wealth-lab.com, www.amibroker.com and www.traids.com.
In addition, with software like Tradestation, one can also do a wealth of backtesting.
Of course, any testing requires you to have a certain amount of objectivity in your approach. It's tough for any "feel" trader to test his picks because feel is hard to define. Of course, you don't want to take that approach anyway, right?
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And that is the final word from Winged Foot, where speaking of backtesting, I stopped by "The Complete Golfer" in White Plains and got a "fitting lesson." Over the course of 3 hours I was tested and probed to ensure I had the optimal set of equipment for my swing. I didn't need many changes, but the few tweaks and modifications should go a long way to improving my score.
P.S. from TheStreet.com Editor-in-Chief, Dave Morrow:
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