Random Walk Trading Strategy – Understanding and Backtest Example

Burton Gordon Malkiel in his famous book — A Random Walk Down Wall Street — popularized the random walk model of the financial markets. According to him, the market moves randomly and its direction cannot be predicted with technical or technical analyses. But is the market truly random, and what is a random walk trading strategy?

A random walk trading strategy is a strategy that is, as the name implies, based on random numbers and inputs. As you’ll see in this article, even presumably solid trading strategies can be made solely by random entries and exits.

The Random walk theory is a financial market model that assumes that stock prices move in a completely unpredictable way. With no degree of predictability in the movement of stock prices, it means that stock prices are random thus using historical prices to forecast future price movements is futile, as changes in stock prices have the same distribution and are independent of each other. The random walk strategy demands that you invest in a diversified portfolio, preferably a broad market index fund.

In this post, we take a look at the random walk concept and how to apply it to trading. At the end of the article, we make a backtest of the strategy.

(We recommend Burton Malkiel’s book. It’s a good book about investing and lets you understand more how markets work.)