Trading as a Science
Many traders approach the markets with a haphazard collection of indicators and rules. A more robust approach is to treat trading like a scientific experiment. This involves creating a specific, testable hypothesis about a market inefficiency and then systematically testing that hypothesis with historical data before risking real capital.
Steps of the Scientific Method in Trading
- Observation: Identify a potential pattern or recurring phenomenon in the market. For example, "The stock tends to reverse after forming a pin bar pattern at a key support level."
- Hypothesis: Formulate a specific, testable trading rule based on your observation. This rule must have precise entry and exit criteria.
- Testing (Backtesting): Test your hypothesis on historical price data. This involves going through past charts and simulating every trade that your rule would have generated. You must record the results of every trade to see if the strategy was profitable.
- Analysis: Analyze the results of your backtest. Key metrics to look at include total profit/loss, win rate, average win vs. average loss, and maximum drawdown (the largest peak-to-trough decline in your equity).
- Refinement or Conclusion: Based on your analysis, you can refine your hypothesis and re-test, or conclude whether the strategy is viable. If a strategy does not show a positive expectancy after rigorous testing, it should be discarded.
The Importance of Objectivity
The scientific method forces a trader to be objective and systematic. It helps to remove emotion and guesswork from the trading process and ensures that you are only trading strategies that have a demonstrable statistical edge. This process is the foundation of quantitative and algorithmic trading.
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