[MUSIC] Learning outcomes. After watching this video, you will be able to understand how to backtest a trading strategy. [MUSIC] >> All right, so you're now equipped fully to handle Pretosky formula, right? So given any company, you will create this f score and you will find high performing companies, not-so-well performing companies, create this long shot portfolio and trade. So that's what you are equipped with now. Now in implementation, there may be a lot issues while we do backtesting. We are going to do a separate module on backtesting, we'll take a strategy and tell you how actually to do backtesting. As I have told you before, the approach here should be to reject the hypothesis, not to accept a hypothesis. So, we are going to talk about it with one example. But when you backtest you don't face any restriction, right? You can trade any stock you already know the prices. You can short anything, go long anything because this is only imaginative. But in real life, there will be a lot of restrictions. For example, in many countries shorting is not allowed. So, Pretorsky formula requires you to long the high performing companies, nine, eight or whatever and short the zero and ones or zero sometimes. So if shorting are not allowed, how do you short zeros and ones? So in such cases or there are a lot of investors who are not comfortable going short. In fact, most investors are not. Because it doesn't come naturally, right? You can always think of buying something that you don't have. But it's very difficult to think of selling something you don't have. Assume that you have raised money from investors you start a fund. A lot of people may not be comfortable with this whole concept of shorting. By the way, why do you need to short in this Petrosky formula? Because to take away the directional risk, right? See, all that Petrosky says that within this universe of high booked stocks, stocks that go higher are likely to do relatively better than stocks that go lower. Petrosky doesn't guarantee that the market itself is going to work, right? What if you have a big market wide event or reinforcing market wide event or an economic slowdown. That would pull every stock down. And that'll of course pull down even the high Petrosky score stocks. So if you're longshot, then you're protected from such downside market movement. Of course you'll have to lose some returns if the market's going to go up. For a long short investor, the focus is the gap between potential winners and potential losers. Now coming back to these implementation issues, if your investors are not comfortable with this whole idea of shorting. It's not a bad idea to have a long only strategy where you just buy the top performing firms. However, you should tell the investor clearly that you are exposed to market risk. If the market goes down, then these stocks will go down. And all this very, very important. In one of the modules we've already spoken about selection of benchmark. S&P 500 or Broadways index cannot be an appropriate benchmark for these kind of strategies when you're doing long only. Why? Because you're trading in these high booked market firms. So you ought to choose appropriate benchmark which reflects the kind of companies that you're going to deal with. And then you can go with the long only strategy as well. You can just buy this eights and nines. And hold it for three months, six months, nine months, whatever your horizon is. Other concern could be that shorting itself may not be allowed, then you don't have a choice. There are markets like India, we operate from India, so there are markets like India where shorting in sport market is very difficult. You will have use the derivative market. The features and options market. If you are restricted to do that, then your universe gets restricted to stocks which are listed in the derivatives segment. If I stock is not listed in the derivatives segment you cannot short it since you cannot use this long short strategy. So, the bottom line is you should consider the institutional realities of your economic setting. What are you going to do? Use this strategy and modify your strategy accordingly. And you can, of course, attempt to log only with high book ed market firms. So that ends Pretosky fully. We will now proceed to talk about post earnings announcement drift, another trading strategy.
