It’s our job to trade “Futures,” not “Histories”
by Joe Ross

Throughout the years that I’ve been trading and writing about trading, I’ve often discussed mind set —having the right frame of mind for your trading, so that you become a winner.

I’ve stated that “It is our job to trade ‘futures,’ not ‘histories,’ but in order to trade the ‘futures,’ we must trade the ‘present.’”

The future is the next bar on your chart.  You can’t possibly know how it will develop, how fast prices will move, or where it will end up.  Since none of us knows where the very next tick will be, it’s impossible to know where the tick after that will be; or the tick after that, etc.  All we know at any one time is what we’re seeing.  Interestingly, what we’re seeing may not be true.

If we are day trading, we are not sure that what we’re seeing is not a bad tick, especially if it is not too far astray from the price action.  It won’t matter that you are trading in an all-electronic market.  The data can, and will periodically, be bad.

The daily bar chart doesn’t always tell the truth, either.  The open may not be where the first trade took place.  The close is merely a consensus, and may be a bit distant from where the last trade took place.  The high may not have been the high, and the low may not have been the low.  If you don’t believe that, then I challenge you to take a look at some of the deferred months.

For example, the exchange has reported that a deferred month opened at 9755, with a high of 9802, a low of 9760, and a close of 9784.  Does that make any sense?  How can the low be higher than the open?  How can the close be higher than the high?  Yet that’s the kind of garbage we have to put up with in this business if we want to develop a test that includes deferred months.

Now you know one of the problems with back testing.  Back testing and simulated testing are based on possibly corrupted data.  That can be one reason why your trading doesn’t work when you actually put your method(s) or system(s) to the test with real data.

In fact, there are many reasons why back testing and simulation won’t work, and I may as well dump them in your lap right here.

Because you can’t truly know where the high or low were, or if the market ever really traded there, you don’t know if your simulated stop was taken out or not.

If you say you have a system in which if you get three up days followed by a down day, the market will be up twelve days from now 82% of the time, then your whole statistical universe may have been based on what is not true.

When you see a completed bar on a chart, you have no idea which way prices moved first.  You don’t know if they moved down first or up first.  You don’t know whether or not prices opened and then moved to the high, went down to the low, and then traded in the lower half of the price range until the close, at which time prices soared up to the high and closed there.  You have no idea of the overlap.  I’ve seen prices trade from one extreme to the other more than once at each extreme.

In any of those instances, your protective stop would have been taken out intraday.

You know nothing of the market speed or tick size on any given day, once you see a completed price bar.  Were prices ticking their normal, exchange minimum tick, or were they ticking two or three times the minimum every time prices ticked?

Even if you have available tick data for your simulation, showing every single tick the market made, you don’t know what the volatility was.  For instance, you don’t know if the mini-crude oil contract was ticking five minimum fluctuations per tick or twenty-five minimum fluctuations per tick, and if it was doing it quickly or slowly.  You don’t know, and you can’t know, and anyone who tells you their simulated system works, based on such phony baloney, is mistaken.

Not knowing how fast the market was means you can’t really know what the slippage might have been; the faster the market, the greater the slippage.  You can sit there and say that you would have gotten in at a certain price or that you would have exited at a certain price, but if you don’t know the tick size, and how fast the market was, you do not know enough to say that you would have done such and such.  Not knowing how fast the market was, you have no way of knowing how much slippage there would have been on your entry or your exit.  Without knowledge of slippage, you can’t possibly know the risk.

That is also true of volatility.  Volatility is made up of range of movement, speed, and tick size.  If you don’t know the extent of slippage, you will not know the extent of the risk you would have encountered.

As if that’s not bad enough, you also don’t know how liquid the market was at the time you would have traded it.  Were traders waiting around for a report or a speech by chairman of the Central Bank? The daily volume might be huge, but if no one was trading at the time you entered your trade, you could have taken an unexpected hit at the time you entered. The reverse is also true.  If a report was just issued at the time you would have entered, slippage could have been enormous.  So here again, you have no idea of what slippage you might have encountered, and once more you would not have known the risk.

A typical way to back-test is to say “entering at the Open and Exiting at the Close.”  Have you ever watched the wheat market open? At exactly 9:32 AM U.S. Central time, Chicago wheat rockets up or down so fast that it is virtually impossible to get a fill at the price you want. Other markets do the same sort of thing; electronic or not, it doesn’t seem to make any difference.

If you want to spend your money on trading systems based upon the unknown, then you must assume the risk of doing so.  Since this is a business of assuming risk, you are entitled to insure prices in any market that you care to.

Insurance companies spend a lot of money to make sure that the risks they take are actuarially sound.  That is the equivalent of finding good, well-formed, liquid markets to trade in.  But any market can become totally chaotic.  Markets can become extremely fast, and they can become quite volatile.  So even if your system was back-tested in a liquid market, when that market becomes fast and/or volatile, your back-tested, simulated system will not be able to cope with it, and you will lose.   It’s like going out to write life insurance on a battlefield.

If your back-tested, simulated system does factor in some room for fast and/or volatile markets, then when you trade in slow, non-volatile markets with the built-in factor, you will be utilizing a system that is totally inappropriate for the slow, non-volatile market you are in.  The best you can hope for is an “optimized” system.  How can you possibly expect to compete with traders who are acting and reacting to the reality that is at hand at the time?

Extensive back-testing is for historians, not traders.  It is the wrong view of the markets.  Your trading must be forward looking, without being ridiculous about seeing into the future.  The future is something you will never be able to see (until you get there).

If you don’t know where the next tick is, how can you possibly know where the next market turning point will be?  How can you see into the future?

Maybe you like to trade astrologically.  Those people are always trying to peer into the future.

In the auto business they have a saying, “There’s an ass for every seat.”  Likewise, there’s a fool for every fortuneteller who claims he can see into the future.

You could always do as one charlatan did, and run the biorhythm for each market based on the day it first started to trade.  Or you can cast the market’s horoscope based on the same date.  With the biorhythm, you’ll know what time of day the market should be on its highs, and what time of day it will be on its lows.

You’ll know which day the market will be ecstatic and reach a new high, and which day it will be down in the dumps and make a new low.  However, you’ll find that from time to time the market will reach new lows on the day it was supposed to reach new highs.  Well, that’s easy enough to explain.  You can tell everyone “We’ve had an inversion.  Until the market inverts again, the lows will be the highs, and the highs will be the lows!“