Why is is that most of the time when looking at charts and backtesting a strategy it seems to work, however, when applying it in real time for some reason it breaks down. This is a real puzzle. Anyone else experience this?
I can't answer you because the forward test I just did will be in the past for you by the time you read this. Hence the result will match your expectation that back-testing works.
Yes, this is because humans see patterns where there is not necessarily a pattern. The computer doesn't have this problem.
Financial markets will never be "solved" by quantifiable measures. As you can imagine, all kinds of sophisticated statistical analysis on super computers has not resulted in a "break through"
What exactly are you backtesting? Different variations of your EMA, Stoch., Fibo, Elliot Wave, Ikumucho's cloud, etc.? Is that what you're doing?
I think you're asking why you can back test a strategy and it works great but then when you actually trade said strategy it breaks down, correct? Well i'm a discretionary trader so this is out of my area of expertise, but from what i've read it has to do with what exckhart calls degrees of freedom. When you come up with a strategy (mechanical one) and then backtest this strategy, the more you add in parameters into the strategy the more you are optimizing it for the past. For instance, say you have a very simple strategy --20-day breakout with a stop at the low of the breakout day and and profit target of 20% rise. This has very minimal parameters. If you backtest this, it should more or less equal future results. However when you start optimizing this strategy with more and more parameters then all you are doing is creating a system that fits well with the past. For instance say that you test it out and it is more profitable if you put in the parameter that you only take trades on Monday/Wednesday/Friday. Well it could be that in the past it just coincidentally happened that the breakouts which happened on M/W/F worked better. That is, there is no viable reason it worked better, just happenstance. Well if you add in this parameter then the backtesting is going to look much better than the real time trading. Because you are optimizing the system. You tested for Tuesday and Thursday and it just happened that breakouts during those two days failed more in the past. The more parameters you put into the system, the more you are optimizing the system based on what actually happened in the past. You are, whether on purpose or not, taking only the good days of the past and eliminating the bad days. If there is a legitimate reason why breakouts work better on M/W/F then there is no problem. HOwever if it was just coincidence then this parameter is going to cause problems.
Do you UNDERSTAND why a strategy is working in backtesting? Do you really comprehend the logic of it? Does it make sense? Can you verbalize it, and see the same circumstances repeating themselves for a reason? Can you sense when it will work, and when it doesn't, and why? If you do, then you should be able to make adjustments and understand why it might be having problems in real time. On the other hand, if you're just throwing indicators on charts and running stuff through the software and grabbing at anything that shows a positive result in the past (which is how most new traders begin), then yes, you are probably not going to be satisfied with the results in real time.
But what is discretionary trading but recognizing patterns or setups that worked in the past? Unless the analytical ability of the human brain is much greater than that of today's computers, both should succeed or fail approximately the same. There are those who "auto trade" which implies that computers are capable of correct future analysis based on past price action. I think the crux of the matter is that there are few consistent analytical formula and most never discover these methods or, for what ever reason, do not apply them. Those who are successful say it took them years of chart watching to become profitable. Does this mean that the subtleties of long term profitable trading simply elude the neophyte?
1) You may not have properly "defined" the pattern or strategy to begin with. 2) The pattern/strategy can work consistently well, not perfectly well. The method may hit a "losing streak" by the time you make your first trade(s). 3) Perversely, the method may disintegrate permanently by the time you trade it. No matter how much effort you put into it, you will not make any money with it.