[MUSIC] Learning Outcomes. After watching this video, you will be able to understand the need for Back Testing. Hi, now let's talk about the most important aspect of these trading strategies, that is Back Testing. All that you can do with these ideas right now is Back Testing. We don't have future prices, we do not know where the market is headed. So all that we can do is Back Testing. So I'm going to talk about ways in which you do a rigorous back test. What are the things that you are to keep in mind? In fact, the papers, the results presented in the paper, are nothing but result of, you can think of a Back Testing exercise. Because the author has an idea and picks up data and sees whether it has worked for a period of time. Of course, they divide the sample into two parts, they figure out the strategy using one sample tested on the other sample. They do all that, but all that goes on is Back Testing. Now, given that the authors have already back tested, why do you have to do once more? There are two reasons, one, you may not be training in the United States, so these are all strategies that have worked in the US. And the second, most important reason, is that your purpose and those author's purpose is different. You want to actually make money, trade and make money. Not to show that there is a particular kind of market failure, or a particular type of asset pricing formula doesn't work, that's not your purpose. So you want to actually see whether it makes money. And, more importantly, there's a third reason, there's a famous saying which is attributed to Canes. The market may remain irrational longer than you may remain solvent. Now, on an average, something may work. It's possible that over a five year period, a particular strategy has given you some fabulous returns. But if there are periods in between, if there are times in between where there have been massive shocks. The trader might get wiped out, especially those who are trading using margin. I already told you, in the previous module, that 15% shock and wipe out are margin trader. The next day's stock, think about a trader who takes a position using margin. And the stock price is 100 and he invests 10 as margin and the stock crashes by 15%. He loses all his margin, puts another 5 from his pocket, stock goes another 10% he has to put down another 10 from his pocket, and he will give up. And soon after he gives up, stock maybe recover 50%, but he will not be there to see that recovery, that's the whole point of this gain statement. Market may remain irrational longer than you may remain solvent. All this formula may be right, that stock price will come up or reach a particular level, but what about the fluctuations in between? So when you do a Back Test, you have to remember that as well. What type of shocks your strategy will be subject to? How deep will be the shock? Or how deep has been the shock? Nobody knows how deep will be the shock, but how deep has been the previous shock? And what kind of capital you're likely to have when faced with that kind of shock. Will you be able to survive? Suppose you face the same shock that happened a few years back, will you be able to survive, that's another question. A fourth reason why we need to worry about these shocks, especially when you're dealing with others' money. You may be super confident about your abilities, you may think that you will do well over a long period of time. But investors who have given money to you may become impatient, say, in few months. Three months of continuous under performance may be enough for a number of investor to pull the plug. So, they may ask for refund of their money, return of their investment, not return on. They may ask you to give back their money exactly at the wrong time. You may know that, after three months of under performance, this strategy's likely to outperform in the next three months, but the investors may not believe. That is another reason why you have to worry about the shocks, and how much downside a strategy has. So a total Back Testing, a scientific view of Back Testing, is important before you embark on a trading strategy.
