What is Backtesting?

Introduction

Trading is a game of profit and loss. No one is happy losing their hard-earned money in the process of trading. Hence you would certainly make sure that your trading strategy will be profitable before employing it in a real-time environment. So you have a strategy but you are not sure of how it will perform. Backtesting will help you get started.

Backtesting is crucial for any profitable trading strategy. It helps you to analyze your strategy and see how well it performed over the past years. It does not substitute for a real-time experience but it will help you in your journey of becoming an algo trader. In the coming sessions, we will dive deeper into backtesting and why it is important.

What is Backtesting?

Backtesting is the process of evaluating a trading strategy to see how well it would have performed in the past using historical data. It helps traders to determine the viability of a trading strategy by analyzing its risk and profitability. A strategy that yields positive results during backtesting is likely to do the same in real-time. Hence traders will have the confidence to employ the strategy in a live trading environment.

Backtesting should also include all the costs incurred in the course of trading no matter how minimal they are. These can add up and significantly affect the profitability of a strategy. For the development of a viable trading strategy, all trading costs should be accounted for whether the test is automated or done manually. Backtesting gives you a hint of what to expect in real-time trading and the confidence to proceed with your trading strategy.

How Does Backtesting Work?

Backtesting is based on the theory that what worked in the past might work in the future and what failed in the past might still fail in the future. Backtesting tells you what happened over the past years but it does not guarantee future performance. However, it can tell exactly how a strategy performed over the years. This might be a good indication but that does not mean it will continue in that order.

The market condition should be put into consideration when carrying out a backtest. A strategy that worked in the bull season might not work in the bear season. Hence, the need to use historical data that reflects the current market condition. Also, backtesting is effective for trades that follow the same set of rules for trade selection, entry and exit.

Benefits of Backtesting

Backtesting is used by both beginners and expert traders to test their strategies. A well-conducted backtest that yields positive results is likely to yield profits when employed in live trading and the one that yields sub-optimal results will be disastrous if not rejected or modified. Backtesting is a great tool for profitable trading. Backtesting can also help to:

• Improve your trading performance as a beginner and even as an expert trader.

• Evaluate how your trading strategy would have performed in the past.

• Optimize the system parameters for improved performance.

• Determine your win-to-loss ratio.

• Understand when best to apply a particular trading strategy for better performance.

Backtesting vs. Forward Testing

After analyzing your trading strategy using historical data, it is paramount to test it first on a live market before committing any real fund. This is known as paper trading or forward performance testing. Paper trading is similar to live trading only in that you don’t risk real funds. The term paper trading is used because all the trade entries, exits, profits and losses are documented but no real fund is involved.

While backtesting shows past performance, paper trading helps you to optimize and restrategize if need be. Both cannot substitute for live trading but they go a long way to prepare you for the real journey. In summary, paper trading helps you to:

• Optimize your backtesting results.

• See how well your strategy will perform if employed in real-time.

• Build up your confidence level before going live.

Whether it is paper trading or backtesting, it should be carried out without being biased or letting emotions set in. In other words, no “cherry picking”. These two steps are crucial before live trading and committing your money.

Conclusion

Backtesting tells you how well your trading strategy performed in the past years, but it does not guarantee future performance. It is a crucial step in the journey of any successful trader. Beginners likewise experts can employ it to improve their performance. When backtesting, market conditions should not be left out as a particular trading strategy might not be profitable all round. Developing a viable trading strategy should involve backtesting, paper trading, live trading with small amounts of capital and finally live trading with increasing amounts of capital. Before putting in a bigger amount of money, you should be ready for any outcome.