Backtesting the Bumblebee (Part One)

After one has formulated a trading idea, coded it and tested that the code does what it's supposed to do, it's time to put the notion to a test based on historical data. Don't be scared and quit biting your nails. This is good for you. Backtesting is the arbiter of the trading idea. You can't make the swim team unless you can first swim across the length of the pool. You cannot trade a system that has not shown it would have actually made money in the past. I'm assuming you are a trader whose objective it is to make money in the markets, and if you're a different sort of trader, you may not want to keep reading. By the way, I pass no judgment on you if you choose to trade for reasons other than to make money. For the profit-minded sort, it will not require too much persuasion to convince you that we only want to trade systems that have shown potential for making money. Backtesting will show that a system either has the potential to be a traded with real money or is nothing more than whimsical fantasy. If you suspect your trading idea is whimsical fantasy, then you may choose to keep it somewhere safe, because this is going to get a little rough.

I'm taking 20 years of data to backtest Bumblebee. You will recall that the system is a trend-following system that uses a Bollinger Band around the slow moving average to create four lanes for our faster moving average to occupy. We enter long when the fast is in the upper lane, and close the trade after it moves into the third lane. We enter short when the fast MA is in the bottom lane, and cover when it breaches the second lane from the top. Entries and exits are on the open of the next bar.

My market for the initial test will be crude oil (continuous contract). I'm only backtesting the first 10 years of data and leaving the second block of 10 years in a super-secret location that the system doesn't know about. I told you it was going to get rough. Below are the results of how Bumblebee performed from Jan 1, 1987 to Dec 31, 1996.



You will notice that the annualized profit of this system is 45.24% over this 10-year period. Not bad. But hold on skippy. We should be asking ourselves if all the profit came from one year while the other nine years were pain-suffering malaise. We don't know from our first run of the data. So it's time to get granular. We are next going to divide up that 10-year block of data into five 2-year chunks. That way, we can check if the system is consistent or if it gets lucky once a decade. Before we do that, let's notice some other characteristics of the system.

Winning percentage is less than 50%. Not atypical for trend-following systems, but if you're psychologically disposed to having the bulk of your trades being winners, you may decide it's safer to eat glass than to trade this system.

Profit factor is 2.56. That means at the end of the day, our gross winnings outnumber our gross losses by that factor. If we were to break even for the period, we'd have a profit factor of 1.0. Any number below 1.0 is a net loser. Obviously, we'd like our profit factor (PF) to be large. It would mean money is flowing into our account, and we are charged little to be at the table. Our profit factor is not bad, but let's keep an eye on it just the same.

Net profit as a function of maximum drawdown. I'll admit, it's a mouthful. Basically you're trying to see how much pain you must endure to realize your profits. With the handy little calculator provided free-of-charge on your PC, you can see that Net Profit ($43,590) divided by Max DD ($9,640) is 4.52. Essentially, we put one dollar at risk to make $4.52. This number goes negative whenever we are overall losers. An interesting metric we shall also keep an eye on.

Long returns versus short returns. It's not in that crummy little graphic above, but let me just tell you what it is. Longs had a 59% annualized return while short trades had a annualized return of 36%. Not totally skewed either way. That's a good sign that the system is not overly disposed to either the long side or short side.

In Part Two we will see the results of crude oil divided up into five equal 2-year periods. And then to test the robustness even more, we will do the same thing on eight other markets so we end up with 45 reports. Five reports per market, nine markets total. This is why I purchased Excel.