318 · Dave Mabe - The Shift to Systematic Trading — Building Backtested Confidence

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you know, unemotional. There's a lot of emotion, and it's exactly what you just described there. What do I do? Here I'm in this drawdown. What do I do? That's an emotional thing. You're not making a decision during the day about that, but it's definitely an emotional decision. And Every trader that ever quit trading did so during a drawdown, right? They're not they're not quitting at all time highs. So that's the hardest part of trading is having the confidence to trade through a drawdown.

Tessa here. As always. Thank you for tuning in to chat with traders. You know, since two thousand fifteen, we're one of the longest running long form podcasts in the world dedicated to trading. We've had in-depth conversations with professional traders and industry experts exploring the realities of markets, speculation, risk, and what it truly takes to achieve sustained performance.

Today's episode three hundred eighteen is another strong example of that. What happens when the thing you believe is your edge, your intuition, gets beaten by your own back test? Today my co host Ian speaks with Dave Mabes. A trader of over two decades who began trading during the dot com era, moved from swing trading into day trading and built a rule based gapping breakout framework centered on defined risk, position sizing, and expectancy.

But the real turning point in his career wasn't the strategy itself. It was the moment he tested it and discovered a systematic version that outperformed his own discretionary trading. That humbling realization pushed him toward automation, scaling from hundreds of trades a year to thousands, and rethinking how to manage drawdowns and diversification. We also dig into gapping breakouts, R multiples, why traders often misunderstand backtesting, the gap between simulation and live results.

and how to build real confidence in the system before sizing up. You'll find additional background and resources from Dave in the show notes. Now let's get to the conversation. Ladies and gentlemen, we're so pleased to present Dave Mabe from North Carolina. Well Dave, uh like to welcome you to uh Chat with Traders. Thanks very much for having me. This is uh quite an honor. Yeah, uh so where where are you at now and where did you grow up?

I live in Carboro, North Carolina, which is just outside of Chapel Hill, which is sort of near Raleigh. I grew up not far away in a small town called Pofftown, which is near Winston-Salem, North Carolina. So yeah, I'm a lifetime North Carolinian. Uh-huh. With the accent too. Yeah. Yep. How did you first get introduced to the financial markets?

So my dad was always investing in some way. In fact, we had cattle uh for a couple of years as an investment. So he was always kind of dabbling around. He was very conservative with money. But always sort of uh dabbling around and investing and uh, you know, uh very much a saver instilled that mindset in me. So I had it the sort of exposed to it at kind of an early age. And when I went to college, I went to UNC uh Go Heels.

I had a modest scholarship at the time and my dad said, Hey, if you get a scholarship, I'll give you the money that we've saved for you, you know, at when you graduate. So he did that, which was I was a great idea. I did the same for my daughter. And the first thing I did when I graduated was put it into a mutual fund. So that was my first real trade, so to speak. And over the years, my time frame just got shorter and shorter. And but but that was my very first uh interaction with the market.

And uh were you pleased with its performance over the years and and did you track it frequently? So I I held it for about a year. This was right during the dot com era. So it worked pretty well. But I I something in the back of my mind I felt like I didn't have control. I I wanted I just wanted to be more in control of what was going on. I at that point I started doing a little bit of research and started swing trading.

Uh and were you um following much what was going on there in the in the dot com mania and what kind of uh stocks did you get into? You know, growing up with my father who was like I said, very conservative, I didn't I wasn't very risky at all. So like this mutual fund purchase was kind of a big deal. So I I knew that my dad

Like the more I started inching toward trading, the more he was gonna sort of raise his eyebrows and like, what in the world are you doing? This seems so crazy. So I was always Very skeptical, very Just uber prepared, like thinking through worst case scenarios all the time. But I started swing trading and I actually was just following somebody who was giving me picks, right? Like a like a trading room sort of at the time.

That it worked pretty well, but all of a sudden the guy went on vacation. So there were no stock picks. I was like, Well, this is not gonna work. Like I I can't be reliant on somebody's uh somebody else's schedule to take trades or not. So that got me just thinking about okay, what might the next step be? And I remember I I remember a particular trade at the time. I was in, I think it was I'm pretty sure it was RFMD, which was a local North Carolina company.

Of a darling company at the time, and people that I respected were it's oh yeah, this is a great, uh, a great thing to buy. So I bought some, I think, right before earnings, and earnings came out. Lo and behold, they beat earnings. And I was like, man, this is gonna be great. And then of course the stock tanks. So I'm like, okay, this makes no sense. I'll never be able to predict that. So just like with one trade, I was like, okay, I I need to take some other approach that I can really

get my mind around and feel like I have some sort of edge. I knew I didn't I knew I was never gonna have an edge in like predicting how the market was gonna react to an earnings thing. That just didn't make any sense to me. So at the time there was Sort of a vibrant, a very vibrant trading blogosphere. And there are a lot of people sharing different ideas.

So uh sort of dove in there, you know, exchanged ideas with s uh some some well known bloggers at the time and came upon this day trading system that they were trading. So I I looked closely into that and said, okay. Let me see how this would work. And like I said, conservative background. I knew I was going to tell my dad I was going to be day trading now. So I really wanted to cross my Ts, dot all my I's.

And really think through, okay, does this make sense? There's a lot of snake oil out there. Let me think through this and and make sure I've I I think of every sort of scenario that could happen. And a a lot of it made sense to me. When I started making trade, this is probably 2005.

I without made my first day trade. And I really feel like that was kind of the first real trade I made. You know, the more I've thought about it and the more I was interacting with other people, I was like, well, this this makes so much sense because I'm not holding overnight. Well at the time there was not much after hours trading, so that's when all the news came out.

I knew there was gonna be times where I couldn't avoid an overnight gap. It just made a lot more sense. And and then plus you have four times your buying, you know, your equity buying power intraday versus overnight. So I was like, wow, this This makes a ton of sense to me. And so I started doing that, you know, very

cautiously to start and it worked well right from the beginning. Define well, like like how how how uh did it perform compared to uh your previous trading that you had done in the preceding years. So the swing trading I had done was actually it was not bad, but but what I realized pretty quickly was it was gonna be many months. really before I could get enough at bats or enough trades to really see if it works or not, to really convince myself that it works.

So that was another thing that drew me to day trading was okay, I'm gonna get a ton of at batch or the potential for a ton of at bat. So I could see much more quickly whether something was gonna work or not. And that just really resonated with me. So even though the swing trading was did fine, if it did it did well, I really felt like this was a better path for me and I could get away from you know following a guru and really taking full control of what I was doing.

Um, how did you go about the stock selection of uh what to day trade? Uh did you just wait for this group to tell you what to day trade or did you venture out on your own? So so that they were trading a very specific system and I just the I mean the rules were out there and I just You know, started following the rules and interacting with one of the bloggers who was was sort of somewhat of a mentor at the time for this system.

I started trading the system and I would, you know, follow up with the trader at the end of the day, say, you know, the mentor, hey. You know, was a good day or bad day. What do you think about this trade, that trade?

So while it was, I didn't realize at the time, but it was pretty it was pretty systematic. There was there was a little bit of discretion in there in like what trades you would, you know, what names you would put on the list or take off the list. based on some intuition. But but it was really good to have these rules.

Thinking back, like the the big part of it was rules that I didn't have to make decisions during the day or that many decisions during the trading day. Humans are just hardwired to do the least profitable thing if you're if you don't have a plan. Oh now why why is that? What what is it about human psychology? Why would we want to do the most unprofitable? I I I think that there's just so much emotion with money and the way people think about money and their history with money.

You're always wanting to get out early or or hold on too long. And coming up with a plan is hard. You have to look at a lot of data and figure out what works across a large number of trades. I mean, just think about how long that takes after hours. Now, if you try to do that during the day when you're in a trade and you got this uh

You know, you're seeing your PL bounce up and down, waiting on you to make a decision. Like you're really like coming up with a strategy on the fly, which is really that's just too hard. It's not gonna work. It may work for a little bit, but it's just a way harder approach for a lot of people. What were some of the uh kind of so called rules or systematic approaches that uh this group had that you learned early on?

I actually trade a version of this strategy still to this day. So they're basically trading gapping stocks. And looking for a narrowing range after the open, after they've they're gapping up. Uh looking f you know, they would get in on a breakout of the range. And use a stop on the other side of the tightening range. And then they would just hold all day.

And it wasn't, you know, a group we to call this gr group a group was sort of uh uh maybe a little too much. It was sort of a just a loose conglomeration of blogs at the time, which is it's kind of a shame that the that blogosphere disappeared. I mean a lot of social media has is sort of taken the place of that, but it was a pr pretty vibrant blogosphere where a lot of people sharing ideas at the time.

What was your approach to or what was what did you learn about uh position sizing and when or when or whether to add to a position? That's one of the things that I knew from my research before I even made the first day trade that I had to get position sizing down pat. There was no that was like non-negotiable. So that's one of the things I was uber prepared for is how to compute position size.

And that's sort of the one of the reasons this strategy works is when the range is pretty tight, you get to take a large position size. uh you're risking the same amount of money and with the tightening range you can take a lot of shares so you end up with these pretty large position sizes for and and you can make a lot of money on a pretty small move. That's sort of the reason this strategy works.

You know, uh another thing that I had down pat before I made the trade was uh the concept of expectancy and R multiples in evaluating your performance in terms of R. So important. And there there's just so many benefits to doing that. And this particular strategy lends itself really well to. using that approach for evaluating it.

And uh so what were your uh uh risk management uh strategy? Did you just set a stop at a percentage below your current price or was it contingent on what you saw in the in the charts at that moment? And it would vary significantly. Setups would come along and and materialize. And then the setup was would determine the stop distance. And then I had

My criteria was, you know, I was gonna ri uh I was gonna risk a certain um dollar amount per trade. And then over time, as I got more confident, I would raise that over time slowly. Yeah, once the signal came along, it was there was no discretion about what to do. Okay, you take it you take it with size X. So you you traded this one strategy for a while. You were you happy with the performance and just kept milking it until till something happened?

So I yeah, I kept trading it and I I traded it for probably three or four years. And, you know, it wouldn't make money every month, but it was making money each year. And I would notice some things. Like one of the first things that I realized was the people that I was interacting with were essentially trading the same system, sort of. But

There were days where I would say, okay, here, you know, man, we had a really bad day today. And the other guy would say, Oh, I I made money. What's what happened? And I realized that Uh I said, Well you didn't take trade X, Y, Z?

And he would say, No, no, I've got a rule that where I exclude trades like that based on, you know, I think it was like relative volume above three or something. And I was like, Oh, well, that's interesting. So how'd you come up with that rule? And he he told me, you know, just

basic intuition or you know some experience, blah, blah, blah. But it made me realize that that's why people who think they're trading the same system can end up with so so much different results. It's because some w people are better at skipping the right trades. And taking the right trades, right? So when you see people trading this basically the same strategy and having different results, somebody is just just has a much better way of figuring out which trades to skip and which ones to take.

So how often were you taking trades that in retrospect uh you felt you should have skipped even though they met the criteria for that strategy? I think the whole name of the game and what I what I came to realize was that is the entire point. Like how That that was that was a path for me to come up with strategies was come up with the initial idea. Don't really worry about applying too many rules. Like you've got a general concept.

and then figure out what rules to apply to figure out, okay, I'm I'm skipping these, but I'm taking these. And it wasn't until I started back testing where this really dawned on me as a way to really create my own strategies. At the time this there was uh you know backtesting was a little bit I would say frowned upon that um it didn't reflect reality so a lot of the people in this group were sort of kind of down on it.

What why is that? Why why would they be down on on collecting more data to improve their system? I think they thought that, you know, it just didn't reflect reality enough. Like there was a and probably they had some discretionary intuition that they didn't feel like could be recreated. And that's kind of what I thought too.

You know, I would have, you know, stocks that would meet the loose criteria. I would sort of use my intuition to say, yes, this one should go on the list. This one shouldn't go on the list. And I was doing that in real time. My assumption was. I had been doing this for a while, I've been doing it, you know

making money with it. So I was like, well, there's no possible way you could capture my awesome intuition with the back test. Right. So at uh also at the time I was working for ATT, a job on the side. And I was doing a lot of automation work there. So I was doing a lot of development. And the more I did that, the more I realized, you know, back testing makes a ton of sense. Why would I not

Do that? Why why would I not try it? I was like, okay, I don't care what these other people are saying. I'm gonna, I'm gonna try it. I did the work to Create my first back test. And I was trying to recreate what I was doing. Uh and my thought process was, well, yeah, I've got some discretion in there, but let me see. Maybe there's And and and whatever back tests I come up with can't possibly be as good as that. But let me see maybe there's something I can learn to apply to this.

So the what shocked me was the very first back test I ran was better than my manual trading. Uh why's that? I think what I found was just like a methodical way to figure out which trades to skip and which ones to take and comparing that to my intuition and I and I was keeping track ke keeping meticulous records of all the trades I was taking. And I was keeping meticulous records of the discretion I was using.

for okay, does does this meet the criteria, does it not? And and, you know, does this meet my sniff test? And what I found was my discretion wasn't nearly as good as I thought it was. So I was like, okay.

Well which as you can imagine is pretty humbling. Right here I was You were still doing good with it anyway, right? But you thought you were in your back testing it was better. It was better. So yeah. Crazy. I never thought this would be the outcome. The very first back test I did. That seems insane. But it really opened my eyes to, wow, there's a whole world out here that I'm ignoring by not back testing.

And there's uh paths to new strategies, paths to improve the strategies I'm trading by like really diving in and taking a f a fully automated approach with how I was trading. Are you ready to get serious about trading? Then join Tasty Trade, Investopedia's best platform for options trading in twenty twenty six. Stocks, options, futures, and more. Tasty Trade has everything you trade all in one platform. Get low commissions, including zero commission on stocks.

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For back tests, uh what are the essentials uh in a back test? And how do we know if we're just cramming too many things in the back test, always trying to perfect it and tweak it and what have you. Yeah, it's a bit of an art. Um I I think the the best way to approach it is to do to create a back test that's

sort of tangential to what you're already trading. You know, a lot of traders will try to completely replace what what's already working. Like maybe there's a j they're a discretionary trader, they want to completely replace what they're doing, but I don't think that's the right approach. A much better approach is to keep doing what's working, create something from the ground up to be automated.

And so that way it's completely additive to what you're doing. And there's not this cutoff point where you say, Okay, I'm discretionary now and then tomorrow I'm gonna be automated with the same thing. I mean It's like software projects in general. They take way longer than you imagine they will. Uh, there's always gonna be problems that come up that you haven't thought about. So there's just a lot of pressure, especially with something that's working already and you wanna cut over.

And you know, a lot of discretionary traders I work with will that they don't realize how much intuition and experience they have to create ideas that are automated from the ground up. You know, if if you've been able to trade discretionarily and you've had some success. Y you have more intuition and experience that you can draw from than people realize.

Uh so after you did this um first back test and you say, wow, this is better than what I'm doing now, uh, did you just run with that, say, great, I've I found the solution and and here we go. Let's let's uh let's maybe even increase the position size. What I did there was I I I didn't do it overnight, but I realized okay, this is gonna this is this has to be better than what I'm doing. So

I I didn't switch overnight, but I did start gradually automating some parts of what I was doing to get closer to that back test. You know, I would um, you know, automatically compute the position size. uh for a while and then I would automatically enter my exit orders. Um, after entering the position. Then maybe another step would be, you know, actually entering the entry orders and have those.

submitted by the computer, but then have to manually hit transmit in my broker to actually make them live. So there was this whole series of steps. that I was going through to sort of get more and more confident so that it wasn't just, you know, wake up day one and have uh the software that I'd written try to make all the trades with with a lot of size, right? That would I knew enough about software to know that that would was not the right approach.

And so how did the early live uh trading experiences uh compare to what the back test uh showed? There were they were pretty close, but it's never gonna be perfect. And I knew that going in. Like I I knew that having a back test is a gr was a great reference, but I also knew that

you know, you're never going to get all those fills that the back test can get. But, you know, the back test was good enough where I knew there was I had a lot of leeway there. So even if I got just some portion of them, it was going to be worth it. At the time, I had created an online trading journal. This was the first online trading journal that existed at

As far as I know. Uh it was called Stock Checker. So I had an API for that and I hooked up the my software to it. So it was automatically entering trades into my journal with all the slippage. accounted for and it it gave me a way to very easily do a back test at the end of the day and compare my actual trades to the back test. So I could see I was in a report that was automatically generated from me, here's the trades you missed that were in the back test.

And then I would go back and look and see, okay, well, how could I have gotten that one? Like could I adjust my entry order to be able to capture that trade that I missed? Like why did I miss it? It was just this feedback loop that I created for myself. that I I I I knew was a path to confidence for me because If you think about discretionary trading, it's You don't really have your only reference is your experience or what somebody's told you. And

It's really important to have a path to confidence. I'll I like to say that it's, you know, trading is not super hard if you're trading with small amounts of money. But as soon as you start really trying to scale up to make lots of money, That's when things get really difficult. Um why is that? I mean, why shouldn't it be the same? Uh uh is it because we're trying to uh trade large sizes relative to the Securities or I mean

There's a whole host of reasons. That's that's one of them. But another is just the way you think about money as as you trade higher and higher, the numbers get bigger and bigger. It takes a certain kind of mindset to be good with that and still at some point Once you reach a certain size, sometimes you you sort of have to earn your keep at that size.

before you and spend some time at the SIs before you can go higher. A lot of times you'll see mistakes that you made earlier kind of crop back up when you go to a a a higher size. And the mistakes with automated trading are different than discretionary. You know, a lot of traders will will try to

to go completely automated to get rid of their emotional, you know, emotions that they think is affecting their trading. But, you know, there's a lot of sizing mistakes. That are emotional and uh can crop up when w even with automated trading. Uh often I hear uh people talk about how important it is to get uh live uh to do the live training and compare it to the the back testing and how uh how often how different it can be.

Well what are the scenarios that um people can use to narrow that difference? Why do you think that some people experience huge differences between the live and the back test? Uh and how can we get those two to be more similar? So it it varies a lot. By strategy. So some strategies are really fast. Some are slow. And so the the differences you see are going to vary a lot by strategy. But there's typically things you can do to to to get a handle on it and and make some adjustments.

to capture more of the trades that the back test is taking that maybe you're missing live. Really before you make your first automated trade, ha have a process for reconciling so you c so you're at least seeing the differences and brainstorming, okay, what could I have done differently here or how can I adjust the the entry technique I'm using. To capture more of these.

So is one back test uh usually uh good enough? Or I mean, uh to get some statistical significance of um how many would be optimal? Well, I think about it as the number of trades in the back test. And and that varies a lot, of course, by strategy. And depending on the number of trades that your signal produces, you may have to go further back in history to create a big enough sample set to really uh come up with a good strategy for. And and those are the things you can vary it by.

But the in general, the more trades you have in a system, the more profitable it could be. So and I realized that pretty quickly when I was introducing this automation.

It was making no mistakes. Like you know, uh all the mistakes that I was making, it was not making. Like, you know, I don't know if you've you've probably made a trade with with a size that has one too many zeros or one too few zeros. You're like, wow, this is I think the one too few zeros is a lot more frustrating than one too many zeros.

So all those mistakes were eliminated. It was getting better fills because it's just much faster than I could have been. Just it felt like I was coming up on a ceiling discretionarily with how many trades I could take. All of a sudden that went away with automation. So I could take Like I was taking I I went I was just looking at my results.

recently and there was one year where I took, I don't know, 300 trades. And then the next year I took 3000. And it was right around the time that I intro introduced the automation. So it just opened up so many things for me to think about. And it allowed me to use my you know, more efficiently use the buying power I had in a in in a way that was just great and really resonated with me.

How did your performance vary but uh just prior to implementing uh this and then the year after um using the your your strategy? What um Yeah, what was the difference there? I mean, it was probably five times the profit based on this. It was a lot. Yeah. And it was, you know, I think about I I wouldn't think about this at the time, but really I was

Scaling wide versus scaling up. That's the way I like to think about it. You know, you can you can have one system and you know just keep increasing the position size the better it get the better it does and just get bigger and bigger and bigger and bigger. That's P what I call scaling up. But then you could you could also take another approach and scale wide. That's another way to scale.

your trading business, just take more trades, find more profitable trades, and maybe at the same size, but just take more trades and you that's that's another way to scale. Uhhuh, using the same strategy or I mean you were very content, obviously, probably with that that that single breakout strategy, right? Yeah, so I I just felt like uh being able to take more trades would be a better long-term approach.

So I remember having a significant drawdown one year in this particular strategy and I finally came out of it and and I scaled back my size. And I ran the back test afterwards and I thought, man, if I had not reduced my size, I would have made a lot more money. And so the next year, the the next year.

Now the drawdown comes, but I was like, no, I I I've I've learned my lesson here. I'm not reducing my size because I know that it's going to take me a while to get my size back up when I come out of this drawdown. So I'm not going to reduce my size. And of course you can imagine what happens. The drawdown just gets deeper and deeper, right? So

That was kind of the low point of my career, I'd say, because I almost quit. I mean, here I, you know, imagine, you know, I had this basically this one strategy. And put a lot of work into it. I made a lot of money from it. This is what I was. This is what I did. Right. And then I've got this huge drawdown. So I really I thought about quitting because, you know, here you are doing all this work and you're losing money. That's terrible.

Um, I mean that it's a it's a horrible feeling. So I knew that I needed to come up with some way to have more strategies. So h how important is it to find the reason for the drawdowns? Uh you know, when is I don't know why, but the stats say, you know, it happens, you know, good enough. Um I I think the the more backtesting you do and the longer your back test window, the better and and easier it is for you to make decisions about that. Uh and that's another

huge difference between discretionary trading and automated trading. You just don't have that reference to see, okay, is this unusual or not? And sometimes there is a there's a bit of a randomness element to matching the back test and drawdowns in general. Uh that's why I say it's a it's a bit of an art. And as much as people want it to be a science, there's still some uh kind of unknowable or something that you just can't reduce down to numbers sometimes it in in trading like this.

What what gave you the confidence to stick stick with it? I mean, did you um discover something in a new back test or did you create a new strategy or was uh did I imagine you probably felt tempted to tweak the system, right? Sure, yeah. I was uh tweaking the system pretty regularly. I I I think a lot of traders are aren't quick enough to do that.

they get stuck with a certain system and don't want to change it for fear of curve fitting. I I see people all the time that are sort of too scared of curve fitting, I think. And As long as I don't think curve fitting is that hard to avoid, but you need to start from a back test with a lot of trades. And each rule you add to the strategy, you need to make sure I call it, it it needs to tell a coherent story.

So you need to think deeply about the rules you apply to the strategy and why you're adding them and what makes you think they're going to continue into the future. Yeah, that that's a such a critical piece. You know, I realized during that drawdown, every trader that ever quit trading did so during a drawdown, right? They're not they're not quitting at all time highs. Right, right. So that's the hardest part of trading is having the confidence to trade through a drawdown.

Do we set the amount of the drawdown, like the percentage in advance? Say, okay, if I have a uh 10, 15, 20% drawdown. Once it hits that level of a drawdown, then I will do this. Do you pre-plan that ahead of time um so that you don't get your emotions involved in? That's a uh definitely helps a lot because you know, like I said earlier, the the people think that trading automated is

you know, unemotional. There's a lot of emotion, and it's exactly what you just described there. What do I do? Here I'm in this drawdown. What do I do? That's an emotional thing. You're not making a decision during the day about that, but it's definitely an emotional decision. And Yeah, anytime you can have some sort of pre-planned way to handle that is is great.

Can you give us a a a concrete example of a back testing a strategy, like just a few of the things that go into that? Right. So The this original strategy that I traded and I created a backtest from, you know, the rules were already. It was pretty much a systematic strategy already. It was just applying the rules to it and realizing that yeah, I had this discretion involved, but okay, what if I had to trade it without the discretion, what would that have been? So

I created a back test and Amma Broker, which is software that I use to to back test and trade. And I still use that same software to this day. And then it's just about, you know, clearly defining the rules. And that's A lot of times discretionary traders, that's that's a hard part, but the really good traders really have a keen sense.

of what ideas are modelable and which ones are discretionary. So they're constantly looking for ideas that could be modelable that they could put to the side and automate and, you know, have that be part of their business. It's helpful to have a programming mindset, but it's not a requirement, especially these days with LLMs and Chat GPT and such. It's it's a lot easier. I mean, it's never been an easier time to to do back testing.

Oh, I see. So do you use uh AI uh uh currently or in the recent years in and how and if so, how do you use it exactly? Sure. I I use it all the time. I think you're kind of silly to not use it. It it's really helpful as a programmer to be able to sort of audit what it does and

step in when it when it's doing the wrong thing. I see a lot of people kinda create spaghetti code using LLMs these days. But um because they don't you need to have a basic understanding of what you're asking it to do. And the better the more understanding you have of it, the better your outcomes are gonna be from using it. So yeah, I use it to create code. I mean I've created code for 30 years now, but I absolutely use Chat GPT and Claude to create code for me now. Um you mentioned about

Uh something about working with traders. Um, I don't know if you've worked with uh traditional prop traders and uh uh some of the challenges that they might have of transitioning to a systematic trading. Yeah, so uh there are Traders that trade uh with proprietary trading firms that I work with and and varying levels, you know, the the prop space has changed pretty dramatically over the last several years. I mean, there's a lot more players in the space.

Yes, I think it's a I think it's an interesting model. I I work with a lot of traders at SMB Capital and which is you know a of uh a well known firm. Yeah, and it's it's it's definitely a different mindset to to trade prop versus trading your own money. And there's uh advantages and disadvantages of doing it. But yeah, I think it's a uh it's an approach that you know a lot of traders could uh could benefit from and should think about.

Um, in some of your earlier videos that I saw, uh, you mentioned that the majority of your profits come from shorting. What do you think are the unique? Practical problems of shorting that back tests often ignore, like for example, borrow costs, locate availability, hard to borrow spikes and buy-ins. Sure, yeah, those are definitely issues. The the way I think about it is a a back test should be like

the perfection that you're trying to achieve. You're never gonna achieve it perfectly, but I like having a back test that is sort of pristine. So I include commission. in the back test, but I don't try to model slippage directly in the back test. I just know that after the back test, I'm gonna uh I I know that I'll I'll lose some money to to slippage and miss trades.

But I'm doing that after the fact. And and the same thing with locate costs. You can't predict exactly with your back test what the locate costs are gonna be. But that's fine. You can you can do that after the fact. And depending on the strategy, you may or may not have significant locate costs. So that's that's gonna vary by strategy. So yeah, just I I find it better to have

the back test as sort of this pristine thing that I'm trying to achieve, knowing that I'll never quite achieve it. But I I like I I think that's a better approach. A lot of people get stuck Trying to model slippage in like the perfect way and try to make their back test reflect reality exactly. But I think there's It's sort of a fool's errand. You're never going to be able to model it exactly. And with the but that's fine. You don't need to model exactly. You don't have to have a perfect

simulation to make money and you don't need to have perfect confidence to go live with something. So a lot of what you'll learn when you go live, you know A lot of people think that their their work is done when the back test is complete, but really that's when the work starts, right? You're gonna learn a lot after you even take tiny amounts of uh, you know, tiny position sizes trading live.

What what are some of the uh a few things that you learn and then what what do you do? Do you do you do uh more back tests and tweak this and that and like kinda what what's that process look like? So there's a there's an economist That goes that that that works at Duke University has got a really good analogy here. He's got a thought experiment that says, okay, let's say you're building a university.

You've got plans for the big ornate buildings. You've got plans for your quads, you know, your uh grassy areas that are so beautiful. But then where are you going to put the sidewalk? So one thing you could do is You could form a committee. of the professors and the students and like have them sort of vote by committee where the s sidewall should go. Or you could h hire an engineer to figure out where this should go, right?

But he says, no, there's a much better way to do it. And that's uh build a university, put a bunch of grass everywhere, no sidewalks, wait two years. And then go and look at where the brown spots have formed for people walking and put the sidewalks there. That's where you should put them. So there's a little bit of an analogy there with with trading strategies. A lot of people want to really

Come up with the perfect back test, tweak it to get exactly right. But you're not gonna be able to you're missing out on a lot of learning by not going live and trying to make a perfect back test. The quicker you can go live, even at very tiny amounts, the quicker you're going to learn and be able to apply back to your back test some things you discover by seeing the live trades, even at minuscule size.

What are some of the common wisdoms uh that you found that you debunked when you uh did backtesting? You find that there's a lot of BS out there. Backtesting, I felt like is a superpower for traders. Like it you you don't have to believe, you don't have to take things at face value that you hear everywhere. I mean, there's all sorts of um things that that traders say or you know, gurus say that are just completely false. Like well, like one of the One of my favorite ones is

Let's say you're in a profitable trade and you're not sure what to do. A lot of people will say, all right, take half off, move your stop to break even, and uh that's what you should do. Like take a partial profit. But if you ever go and do the back test on that. And compare it to not taking a partial profit, it's like night and day. Like you're losing so much money by doing that. Um, and not carrying your full position size to the uh a a natural.

Your natural exit. You can just go and do the back test and see that it's a it's a terrible idea if you do that over and over and over. And what what about uh setting stops? Uh is um what have you learned about that? Stops in general make strategies worse. Of course, they're required to actually for mere mortals to trade a strategy, right? You have to limit your risk. But one of the things I like doing with the back test.

is making sure the back test works without stops and targets initially. Like run a version without stops. And it should work then. It it better work then because the stop applying stops, which you should always do. uh i is gonna make that worse. But I like running it without stops because you you're gonna avoid some of the biases that come with with back testing.

You know, using a a a very tight stop, a lot of times you could make a strategy appear to be good when you use a really tight stop. But in reality, you're gonna get that stop is gonna get hit, but the back test doesn't suggest that it would. Why is that? It's because the precision on the back test isn't precise enough. So, like let's say you're back testing on one minute bars. And

You got a really tight stop in there. Well, on the entry bar, there's the decision you have to make. Are you gonna let yourself in the back test get stopped out on that initial bar? Are you gonna wait one bar? A lot of traders choose to wait one bar. And if they got a really tight stop that would have gotten hit on that entry bar.

In the next bar, it it's not going to get reached. So a lot of those trades that you would get stopped out in real life end up looking good in the back test. So having, you know, understanding that is really important and a lot of traders will say, Okay, well I'll I'll just

I need to create a tick-by-tick back tester. That's the answer. And there's some back testers like that that exist, but it's a really hard and resource intensive thing to create. So There's a cost-benefit analysis there. And you can get by without that extreme level of precision. And as long as you understand how the back test works and how those precision issues will sometimes make the back test look too optimistic. Excuse the last interruption here. This is Tessa.

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Uh do you ever do forward testing? Uh I mean, and if so, what kind of what are your thoughts on forward testing? I th I think about forward testing as just taking live trades with really small size. As long as you have a good process for reconciling and and noticing where the the back test isn't measuring up and why, then you can learn very quickly and you have a much quicker path to confidence.

I I only know of two ways to gain confidence in a trading system. That's when one is just trade it over and over for a long period of time. And the other one is back testing. So it's sort of a shortcut to confidence. And that and and confidence is really that it's so important because uh if you don't have confidence in strategy, you're not gonna be able to trade it with significant size, which is required to make a lot of money with it.

So having a I I talk a lot about a path to confidence. Like what is your path to confidence? Why are you not trading the strategy now with your full account size? There's probably good reasons why you're not. figure out what those are and see if you can get answers for some of those to alleviate those concerns. And continue to get more and more confident in your strategy. What about like uh drawdowns and say diversification? Uh, what are your thoughts on having multiple different strategies?

Uh, and so that uh maybe you have uncorrelated um strategies hopefully to smooth out that equity curve. Yeah, that's exactly why I when I was in that big drawdown, I knew that's what I needed. Like i I was too reliant on this particular strategy that could go away. So I knew I needed more strategies and I needed a very, you know, a much faster way to come up with them.

So I really buckled down and created tools for myself to be able to quickly come up with ideas and quickly back test them and figure out how to create strategies that I could go live with. So that that was really A a key insight for me. And and I see it, I see it so frequently now. Traders that have one good strategy, the only thing harder than coming up with their first profitable strategy is coming up with your second because you feel like you have you feel like you have it figured out.

And you just like okay, well, I don't I don't care what anybody says. This is working for me now. This is how trading works. And you kind of you can't even

You don't even allow you don't even realize it, but you're not even allowing yourself to think of other ideas. You kind of get fossilized in one way of thinking. But really the way to scale is to add additional strategies and that are uncorrelated and and that's um you know I see that day in and day out and but it but it is really surprisingly hard for people that have are are successful with a single strategy to come up with that second one.

Well, um there's a aren't there a lot of strategies uh off the shelf that um one that's already been created that one could uh tap into and say, Hey, this strategy here looks good. Let me add that. Um uh why Is it why would it be necessary to always have to come up with your own strategy as opposed to adopting one that's already on the shelf? Because the one that's already on the shelf probably isn't that good because it wouldn't be on the shelf otherwise.

Well, do they ever come back into uh d does a strategy that goes dead for a while, does it ever come back into vogue? Have you ever seen that? Sure. I I I I see that. And I see you know, the tools that I created for myself. are basically give me a way to make adjustments to a strategy over time so that as it deteriorates, I've got a way to uh apply another rule.

to get rid of the poorest trades in the system. So over time I've So so when I go live with a strategy, I've gone through my optimization process where I've selected my rules. And then I've selected the the set that I'm going to go live with. But then I continue with the optimization process. So I've got another rule kind of in my back pocket. So that a few months from now or however long when the strategy goes in drawdown, I can say, okay, I've got, I'm not like

caught flat footed. That was the problem with that that big drawdown I was in. I was flat foot. I didn't have I was at a dead end and didn't know where to go. And I never wanted that feeling again. So I keep like kind of a rule in my back pocket that okay, here's one that I could I could apply because I've already done the research for that. And I'm not completely starting from ground zero with the strategy at that point. And that's just a much better uh it's a much better mindset.

For discretionary traders, uh, what's a simple first step toward um automation or being more systematized uh they can do say this week to get started. Yeah. So I would say brainstorm some ideas that Uh you probably already have beneath the surface related to the strategy you're already trading. Like what's what's some set of of trades that almost meet your criteria, but not quite?

That's a good area because you're already probably pretty familiar with that universe. Figure out how to create a strategy from those. Like come up with just an initial idea. and create a backtest from it. Get in a habit of coming up with ideas like this and creating a list and prioritizing those ideas for which ones to work on next. You know, a lot of traders have uh lots more ideas than they realize they do.

Great. So to uh wrap up, uh for those wanting to get into backtesting and who are not programmers, uh, any particular software that you'd recommend? I have a free uh back testing course that goes through the ones I recommend. It's called Better Backtesting. So you can go to betterbacktesting.com and sign up for that.

But the ones I recommend are are on there. Um Amab Broker is one I really like. Trade Ideas. I I worked for I was a CTO for trade ideas for many years. It's it's great because you don't have to write code and you can do some back testing in it. Uh the other one is real test. Real test is

The the only problem is it's daily data only. If you need intraday data and you need to back test on intraday data, then you're not gonna be able to use it for that. But yeah, those are the ones I recommend. That's that's probably the best way to get started. Well, Dave, I'd like to uh thank you for coming on Chat With Traders. Yeah, well I yeah, I appreciate you having me on. Uh there was uh

Yeah, there have been many hours where I've spent cycling in my shed, listening to this podcast over the years. So yeah, it's kind of it's it's an honor to be on here. Appreciate the invite. Yeah. And how can our listeners uh reach you? Yeah, the best way is to sign up for that uh email course is totally free. You'll get emails directly from our personal email. So and that's betterbacktesting.com. And yeah, feel free to reply and yeah, I'm uh I'll read all those emails.

Fantastic. Thanks for coming on the show. Thank you. You've reached the end of this episode of Chat with Traders, but rest assured there are more outside.