Forward Performance Testing Basics

Forward performance testing, also known as paper trading, provides traders with another set of out-of-sample data on which to evaluate a system. Forward performance testing is a simulation of actual trading and involves following the system's logic in a live market. It is also called paper trading since all trades are executed on paper only; that is, trade entries and exits are documented along with any profit or loss for the system, but no real trades are executed.

An important aspect of forward performance testing is to follow the system's logic exactly; otherwise, it becomes difficult, if not impossible, to accurately evaluate this step of the process. Traders should be honest about any trade entries and exits and avoid behavior like cherry picking trades or not including a trade on paper rationalizing that “I would have never taken that trade.” If the trade would have occurred following the system's logic, it should be documented and evaluated.

Many brokers offer a simulated trading account where trades can be placed and the corresponding profit and loss calculated. Using a simulated trading account can create a semi-realistic atmosphere on which to practice trading and further assess the system.

The figure above also shows the results for forward performance testing on two systems. Again, the system represented in the left chart fails to do well beyond the initial testing on in-sample data. The system shown in the right chart, however, continues to perform well through all phases, including the forward performance testing. A system that shows positive results with good correlation between in-sample, out-of-sample and forward performance testing is ready to be implemented in a live market.