Developing Profitable Trading Strategies - A Beginner’s Guide to Backtesting using Microsoft Excel
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About this ebook
Have you ever had an investment idea or heard of someone else's advertised trading strategy and wondered if it would really work? Do you know which technical indicators are effective and which are worthless? Do you know how long to trade an underperforming strategy before bailing out?
This beginner's guide will answer these questions and more. In it, you will learn how to set-up, develop, optimize and trade stock market strategies. You'll also learn:
How to backtest an investment idea
How to judge a strategy's performance for robustness
How to optimize buy/sell rules
How to predict future returns
How to execute a strategy in real time
How long you should commit to a trading system
No matter what your level of expertise, you'll benefit from the included pre-programmed Excel spreadsheets which automate all of the work involved. No programming skills required!
Don't rely on the promises and guarantees of others; prove to yourself a strategy is effective before you ever risk a penny of your hard earned money.
Patrick Grattan
In 2008, Patrick Grattan was an individual investor who subscribed to the buy-and-hold mentality. When the markets crashed that year, he felt a wake-up call, recognizing that investors are merely passengers at the mercy of shadowy market forces. Immediately, Mr. Grattan realized that there was no guarantee that markets should always recover or that buy-and-hold will always be advantageous in the long run. With such future uncertainty, he discovered that the only way to mitigate such risks was by actively managing his investments. Mr. Grattan's principal goal was to design a strategy that would earn consistent profits without the roller-coaster returns of buy-and-hold. The result of his labor was a profitable trading strategy that minimized risk while using the leveraging power of compounding to provide fantastic returns despite market conditions. In 2010, Revere Trading was born, a premier market-timing subscription service that allows others to profit from Mr. Grattan's unique and invaluable strategies. Due to an overwhelming interest by people wishing to design their own personalized strategy like the Revere Trading system, Mr. Grattan authored the book "Developing Profitable Trading Strategies: A Beginner's Guide to Backtesting using Microsoft Excel" in 2013. It serves as a resource that shows others the lessons and pitfalls he encountered while developing and proving his personally-designed technical trading strategies.
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Developing Profitable Trading Strategies - A Beginner’s Guide to Backtesting using Microsoft Excel - Patrick Grattan
Preface
Discovering and developing stock market trading strategies is one of my favorite pastimes. I enjoy exploring what others have done, but inevitably I try to improve on it by putting my own twist on their tactics making it my own. There is a great feeling of excitement when I hit the "backtest" button on a new theory I’m exploring and am validated with exceptional results. Even better is when I have a strategy in place and on a given day, every single stock in my watch list is red – except the stock my trading strategy called for! This is the exciting world of do-it-yourself market strategies. It’s as addictive as a casino but with much better odds of being profitable.
It’s a great time to be a player in this game, too. Today, we have access to real-time stock quotes, cost-effective or commission-free brokerage houses, extensive free historical price data, and computers capable of automating tasks ranging from pattern recognition to robust backtesting and strategy execution. Every tool necessary for success is now at your fingertips. This mix of ingredients is relatively new, even within the last couple of decades, and providing individual traders power that was previously only available to professional Wall Street traders.
This book is structured into three main parts. Part 1 is designed to teach you how to develop your own stock market trading strategy and set it up in a Microsoft Excel spreadsheet for effective analysis. This section is also valuable if you wish to assess the robustness of other advertised strategies independently. To achieve this, I will introduce some Excel formulas designed to describe a trading strategy in a way that computers can understand. Subsequently, we can instruct the computer to backtest the strategy to determine its past profitability. If you are a beginner without experience in Excel, fear not. Once your strategy is defined, backtesting becomes easy, as I have already done the heavy programming for you in preprogrammed Excel sheets. You can download these sheets for free
Part 2 is geared for those interested in evaluating market trading strategies in depth. While it may be tempting to believe that the most profitable strategy among several backtested ones is the best for trading with real money, this is a misconception. Backtesting the past is relatively easy; however, predicting the future is an entirely different challenge. How can you determine the robustness of your strategy before risking real money? What is the actual risk involved? What is your real expected return on investment? Understanding the answers to these questions and how to assess them will significantly alter your perspective on what makes a 'good' trading strategy.
Once you've crafted a strategy and gained confidence in it, you're prepared to start trading. However, it's essential to be cautious, as this is precisely where many traders encounter challenges. In Part 3, we'll explore how you can detach yourself from emotions to eliminate bias in your trading. Given our human nature, achieving this detachment is nearly impossible unless you have mechanical, objective rules that you can execute day-to-day precisely as they were carried out in your backtesting. A practical approach is to set up automated email alerts with specific buy/sell indications. I've developed an Excel sheet that facilitates this process, and it's available for free download.
Note for Second Edition Readers: Originally published in 2013, this book has enjoyed tremendous success. However, I've taken into consideration the valuable feedback and criticisms from readers. I'm proud to present an updated Second Edition for this new decade. Addressing one common critique, the absence of an example strategy in the original edition, I have now added Part 4 – An Example Strategy that Works! In this section, I'll detail the strategy I personally use, its construction rationale, past performance, and future expectations. Upon reaching Part 4, I am confident that you can leverage this example strategy as a foundation for your own, aiming for even greater success.
Throughout this book, I will step you through the process of designing, testing, optimizing and executing your very own market trading strategy mirroring the methods employed by professionals at Revere Trading. This process is designed to be accessible to everyone through step-by-step instructions and pre-programmed spreadsheets that handle the technical aspects. The ultimate objective is for you not only to create your profitable trading strategies but also to develop them swiftly and efficiently to adapt to changing markets. Let's get started!
Introduction: Setting the Foundation of Analysis
Chapter 1 – Why Choose Technical Trading?
The starting place for developing a trading strategy is to decide fundamentally what type of data will form the basis for your trading decisions. Various types exist, with many traders opting for passive strategies like buy and hold or active strategies grounded in fundamental analysis, sentiment analysis, technical analysis, or a blend of these. While each approach has its merits and is widely employed, I personally chose technical analysis for my market timing company, Revere Trading. I recommend considering the same for your trading strategy. Let’s look at each one individually to understand their respective strengths.
Passive Investing - Buy and Hold
Buy and hold is a passive type of trading strategy which involves purchasing a security and then holding it for a very long time. This strategy is very popular among workers with a 401(k) who have limited knowledge about investing. It relies on the fact that the stock market has shown to be profitable throughout history and the assumption that it will therefore continue to be profitable into the future. Essentially, buy and hold is a form of technical trading wherein the pattern of the past is expected to repeat in the future.
The problem with buy and hold is that there aren’t any provisions for adapting to new market conditions. In reality, there is no guarantee that future market conditions will look like the past, especially the far future compared to the distant past. Buy and hold requires a lot of trust in the markets to operate in a reasonable, consistent way. Unfortunately, that is happening less and less due to factors that are contributing to a very uncertain future. In recent years, we have seen markets pushed far into overbought and oversold territory by speculators. We’ve seen major companies cook their books and ratings agencies seemingly oblivious to reality. We’ve seen the rise of hedge funds that are leveraged to the hilt, IPOs based on misinformation, and shocking levels of volatility brought by algorithmic computer trading. The future is also uncertain, with Western countries accumulating unprecedented levels of debt, emerging markets becoming global competitors, and proposals for new global reserve currencies, including digital currency. In this era, we face unparalleled uncertainty, and a continuously rising stock market is far from guaranteed.
As Global Debt Worries Mount, is Another Crisis Brewing?
Reuters, 10/16/2023
Government debt trajectories pose the biggest threat to macroeconomic and financial stability
Persistent Inflation Threatens Four Decades of Investor Prosperity
Seeking Alpha, 1/3/2022
Inflation could lead to bubble market declines like 1929 and 2000
U.S.-China Tensions Could Lead To Attack On USD Global Reserve Currency Status
Seeking Alpha, 7/7/2020
Neutralizing the Fed could result in Trillions of dollars’ worth of US stock market value being wiped out.
Even if we could somehow be guaranteed of an indefinitely rising market, that long-term view may not apply during our specific working years. The graph below illustrates S&P 500 returns adjusted for inflation over a twenty-year period. This timeframe doesn't align with the expectation that markets always rise. If this represented your working career leading up to retirement, enduring the last 15 years of losing half of your money, gaining half back, losing half again, and then doubling your money just to break even would require an iron stomach. What a rollercoaster! And all for a net gain of nothing?
tmp_a264c84a2b989d164059b4b4eebd5792_Ln07Ia_html_m2e7230fc.pngWhile buy and hold was effective in the distant past, its utility has diminished over the past couple of decades. Given potential geopolitical shifts and vulnerabilities in our markets, the foreseeable future offers no guarantees. It's completely uncertain whether your portfolio will show a profit or loss twenty years from now.
Active Investing - Fundamental Analysis
Of the three types of data employed by active investors, fundamental analysis is one of the most widely used. Fundamental analysis relies on using the financial fundamentals of a company to predict its stock’s future trajectory. The financial fundamentals encompass factors such as revenue, expenses, assets, liabilities, etc., serving as key indicators of a corporation's financial health. The stock price is considered a reflection of these fundamentals when analyzed collectively.
The strategy, therefore, involves assessing a company's financial position and gaining insights into its outlook more clearly than most people so that you may be able to make some money as others catch up to your perspective. The speed at which markets adjust a company's price to align with its fundamental outlook is termed market efficiency. Recognizing a disparity between a company's true value (outlook) and its perceived value (stock price) is referred to as market inefficiency. As a fundamental trader, you are consistently on the lookout for these inefficiencies so you can try to take advantage of them as soon as they arise.
After considering the above, do you see any challenges in pursuing this route? Firstly, you must be adept at evaluating a company based on its financial indicators. Learning the meanings of various measures is a significant task, and while there are numerous classes available for learning, that isn't the real challenge. The key phrase here is to judge the company’s outlook more clearly than most people. We’re not talking about joe six pack down the street, we are talking about the circling sharks that do this stuff for a living. These professional traders, armed with years of education, analyze every tick mark and trade every hour of the day. They participate in corporate conference calls, scrutinizing every word from the CEO. They possess insights into government legislation, understand global political dynamics, and employ dedicated analysts to process massive daily data influxes. They are the ones who command numerous fortunes and know how thousands of people are trading their money. They are professionals at fleecing the hapless fool who enters the market on a hunch. These are the most people
you have to beat.
And that’s assuming you can even trust the financial gauges you are looking at in the first place…
Fiat Chrysler to pay US$40 million for inflating sales numbers
Zig Wheels, 9/30/19
The US Securities and Exchange Commission imposed a fine of US$40 million ($59 million) on Italian-American automaker FCA, over the charge of manipulating the sales figures for five years.