Fixing Your Trading Psychology: Valid Backtests & Momentum Strategies

Summary

If your trading strategies work in backtests but fail in live markets, the issue is likely psychological, and fixing it starts with ensuring your backtests are valid. Many traders optimize for the highest possible return, which often leads to finding random peaks that won't repeat. Instead, look for stable parameters that produce consistent returns even with slight variations or added noise. To conduct a useful backtest, define your clear thesis or reason for a strategy's potential success, rather than trying to find every pattern. For example, while the idea of the US dollar collapsing due to debt is a common commentary, there's little historical evidence for it, making it a poor basis for a trade. Conversely, stress in the high yield bond market has shown a consistent correlation with significant stock market risk, suggesting it can act as a leading indicator. Technical analysis alone can be effective for risk control, but using it to predict specific upward price movements has a lower probability of success. Momentum, however, is an exception that can work across markets and timeframes. For retail traders, momentum can be traded through breakout systems with strict risk management. There are three types of momentum to consider: time series momentum, which tracks an asset's own past performance; cross-sectional momentum, which ranks assets against similar ones; and factor momentum, which capitalizes on the instability of financial factor models by investing in currently outperforming factors. These momentum strategies, especially cross-sectional and factor momentum, often require comparing multiple assets, making them less suited to simple chart reading.