CHAPTER 8: FORWARD TESTING

Forward testing is a method of evaluating a stock trading strategy by applying it to current or future data, and then monitoring its performance in real-time. This is in contrast to backtesting, which involves testing the strategy on historical data.

Forward testing is an important step in the development of a stock trading strategy, as it can provide insight into how the strategy will perform in real-world conditions. By testing a strategy in real-time, traders can observe how it performs under actual market conditions and make any necessary adjustments to improve its performance.

Forward testing can be done manually, by paper trading or demo trading, or it can be automated using trading software. The goal is to evaluate the strategy's performance over a period of time and make any necessary changes to improve its profitability.

Paper trading (or demo trading) is a simulated trading process that allows traders to practice trading strategies without risking real money. It involves using a simulated account, which looks and operates like a real trading account but uses fake money to execute trades.

With paper trading, traders can test their strategies in real market conditions and gain experience without the risk of losing actual money. It allows traders to evaluate the effectiveness of their trading strategies and make necessary adjustments before risking their capital in the actual market.

Paper trading can also be used to test and compare multiple trading strategies to determine which one is the most profitable. Additionally, it can be used to test the performance of new trading instruments, such as options, futures, or forex, before trading them with real money.

After finishing the backtesting process for a trading strategy, it is not advisable to rush into real trading immediately. In my opinion, it is better to spend several months doing paper trading based on the strategy to verify its robustness repeatedly. During this time, it is important to update the training set and testing set with new data to ensure they remain relevant and reflective of current market conditions.

For example, besides these Demo strategies which are based on Technical Analysis Methodology and have been displayed in this handbook, I am developing another strategy based on Artificial Intelligence Machine Learning, and have been doing Forward Testing over 2 years. Do you still remember how many things happened during 2020 and 2022?

Let's take a look back at some of the most dramatic events that have occurred during the past 24 months, as well as the 113 groups of forward testing done for this AI-Powered trading strategy:

December 2020: One year had passed since the outbreak of COVID-19;

January 2021: Capitol Hill Riots, USA political turmoil;

August 2021: Afghanistan changed, and the United States accepted defeat and withdrew hastily;

December 2021: Two years had passed since the outbreak of COVID-19;

January 2022: The USA reports that the inflation rate hit 7% the previous month;

February 2022: The Russia-Ukraine war broke out;

March 2022: The Fed raised interest rates by 25 points for the first time in nearly three years; America's inflation rate jumped to 8.5% last month; Shanghai lockdown; The Russia-Ukraine peace talk, which turned out to be a scam;

May 2022: The Fed raised interest rates by 50 points due to severe inflation;

June 2022: The USA inflation rate hit 8.6%, the highest since 1981; The Fed raised interest rates by a whopping 75 points;

July 2022: US inflation hit 9.1%, the highest since 1981; The Fed raised another blockbuster 75 points interest rates; The USA economy grew at a negative rate for the second quarter in a row; Political turmoil in UK, prime minister resigned;

August 2022: China reported unemployment at 5.4% last month and youth unemployment at 19.9%;

September 2022: Queen of UK Elizabeth II died; Russia partially mobilized and the war escalated; The explosion of the Nord Stream gas pipeline between Russia and Germany, worsening the European energy crisis and high inflation; US inflation still high, the Fed raised interest rates for the third time with 75 points;

October 2022: USA-Saudi Arabia relations broke down as OPEC+ announced crude oil production cuts; The Crimean bridge was bombed; UK's new prime minister resigns after just 45 days, the shortest serving in the history of UK;

November 2022: US inflation remained high and the Federal Reserve raised interest rates by 75 heavy points for the fourth time this year;

December 2022: G7 and the European Union set a cap on the price of Russian oil, causing another wave in the international energy supply; The Fed raises rates aggressively by 50 points to fight inflation.

…

See? Every day, we may encounter so many unknown incidents that can affect stock markets, some small like Hollywood stars' fashion dresses, some big like wars. Therefore, it's important to be patient, and conducting more Forward Trading can give you more confidence in your trading strategies.

In short, Forward Trading (Paper Trading or Demo Trading) involves using virtual money to simulate real trading, which helps traders understand how their strategies perform in different market conditions without risking actual money. It allows traders to fine-tune their strategies and make any necessary adjustments before transitioning to real trading.

Additionally, it is crucial to consider the impact of transaction costs, such as brokerage fees and slippage, on the performance of the trading strategy. This is especially important when deciding whether to continue using a particular strategy after paper trading. Therefore, it is recommended to incorporate transaction costs into the backtesting process to obtain a more accurate representation of the strategy's performance.

Forward testing is like trying out a new recipe before serving it to your guests. Just like how you wouldn't want to serve a dish without tasting it first, you wouldn't want to trade without forward testing your strategy. Imagine trying out a new recipe without tasting it first, and your guests end up with a disastrous meal that makes them want to run to the nearest fast-food restaurant. The same goes for trading; you wouldn't want to risk your hard-earned money without testing your strategy first. So, forward testing is like a taste test for your trading strategy - you want to make sure it's deliciously profitable before serving it up to the market!