I coined the phrase, “reality buffer” when writing my book, “Technical Analysis: Forex Analysis and Technical Trading Basics“. A reality buffer is simply something that is added into your analysis to assist you in creating more realistic strategy performance results.
Frequently when testing strategies on historical data beginning traders will not factor in things such as slippage or commissions. It's also easy for them to neglect a way to factor in the realities of human error. The results is that the back tests yield phenomenal performace. After seeing these phenomenal results some new traders dive right in and begin trading with actual capital. After a while disappointment sets in as the strategy's real-time results are nowhere near as spectacular as its hypothetical results. In the end many a decent trading strategy may have been abandoned because it was tested without the benefit of a reality buffer of some sort.
Slippage and commissions can be considered a reality buffer as can accounting for good-old human error. Creating a reality buffer in your testing is actually quite simple and can be done with most strategy testing software. You can start off by simply subtracting 5 pips from every trade. If your next winning trade had a 50 PIP profit and net profit becomes 45 pips. If your next losing trade had a profit of -25 pips net loss becomes -30 pips. Now five pips doesn't seem like very much per trade but imagine the impact it has when trading multiple contracts over hundreds of trades.
Not only can reality buffer save you a lot of wasted time and money, it can tell you a lot about the system that you're testing. For instance, if the inclusion of a very small reality buffer turns your trading system a winning system into a losing system, then you may want to go back to the drawing board.
I will openly admit that using a reality buffer may seem as if it can be a bit discouraging initially. That is simply because the profits of every trading strategy are greater without the reality filter. In reality, it makes a lot more sense to be discouraged during your testing phase then to be discouraged because your losing real money. Remember that the entire point of using a reality buffer is to give us a better idea of how a strategy may perform in real time.
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