What Is Backtesting In Trading?

(Source – MetaTrader)

Backtesting is a method that involves examining how a trading strategy performs by simulating trades based on historical prices and data.

Traders who backtest believe if an approach worked in the past, it should have good performance in the future.

Why Is Backtesting Essential?

The goal of a backtest is to determine if a trading strategy has an edge or not. Should the approach lose money during backtesting, it SHOULD NOT be traded in the live market. However, a profitable strategy on past data is extremely promising and should be tested further in real markets.

How To Backtest

  1. Determine your entry, exit, and risk criteria of the strategy.
  2. What market would you like to test? Markets have different characteristics, so strategies will perform differently, so pick your instrument and stick to it.
  3. Set the start and end date of the backtest, make sure you will make enough trades to have a large sample size to analyze performance.
  4. Start the backtest and simulate all the trades that meet your criteria. Use a platform such as MetaTrader or TradingView so you can place trades just as you would in real-time. The software will also keep track of entries, exits, position sizes, losses, and wins, making your job easier.
  5. Analyze the performance. More on this in the next section…

Examining results

Is the trading method you are testing good enough for you to put your hard-earned money at risk? Here are the metrics you should consider:

  • Net profit or loss – The result of the testing in $ terms.
  • Return – Percentage return over a given period.
  • Risk-adjusted return – Return per unit of risk taken e.g. Sharpe ratio.
  • Volatility – Measures the severity of fluctuations in performance.
  • Drawdown – The highest % portfolio loss during the backtest period.

 

A simple formula to determine if you have a positive expectancy:

Edge = (Average Winning Trade $) x (Win Percentage) – (Average Losing Trade $) x (Loss Percentage)

If this number is negative, DO NOT USE this strategy!

If this number is positive, the next step is performing out-of-sample tests and forward testing to confirm the probabilities are in your favor.

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Positives

  • It allows traders to test strategies without the need to risk capital.
  • You can determine if a strategy is profitable before trading.
  • Time saver as you can go through past market data at an increased speed.

Negatives

  • You need to avoid curve fitting your strategy.
  • Make sure to remove any biases. You must execute the rules to get an accurate result.
  • Don’t look forward before entering a trade to see the result. That would 100% influence your decision-making.
  • Remember to include trading costs such as spread and slippage.

Conclusion

Backtesting is the equivalent of wearing a life jacket while learning to swim. It will stop you from drowning while you learn the skill.

As long as you can quantify your trading methodology into objective rules, then backtesting is for you.

May the market be with you.

Backtesting FAQ

A method that involves examining how a trading strategy performs by simulating trades based on historical prices and data.

Because you can determine if your strategy has an edge without putting capital at risk.

  1. Formulate your trading strategy.
  2. Pick which markets to trade.
  3. Set the start and end date of your testing period?
  4. Start backtesting by simulating trades that meet your criteria.
  5. Analyze the results.
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Guy Seynaeve

Guy Seynaeve

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