What is Backtesting and How Do You Backtest a Trading Strategy?

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Synopsis:

Backtesting is one of the most powerful ways of formulating a trading strategy. In backtesting, we apply a trading strategy to historical data, which helps us learn without risking our capital.
Once backtesting results in a profitable trading strategy, we can use it for our future trades. That said, we need to consider all the factors, like transaction costs and slippages, while backtesting. Otherwise, our results will not be realistic.

What is Backtesting and How Do You Backtest a Trading Strategy?

Whether you are an experienced trader or a beginner, you would agree that trading is a risky endeavour. Unless backed by a well-researched strategy, it can backfire. Therefore, many traders use a “backtesting strategy” to make their decisions.

In backtesting, we apply a certain strategy to past historical data to assess how well it would have done had it been used at that point in time. Suppose a strategy produces good results on historical data, chances are that it may provide you desired results in your future trades as well.

That said, backtesting assumes that stock market movements in the future will mirror the stock market movements of the past. Therefore, you should always be careful while using a backtested strategy.

Introduction to Backtesting

Real-world trading is a serious business. When money is at stake, people want evidence to rely on a strategy. This is where backtesting steps in. In backtesting, you take a strategy and apply it to real-world historical prices. In a way, you try to assess what would have happened had you applied this strategy in real time.

If this strategy works on historical data, you then try to apply it to your future trades, hoping to make money. While performing backtesting, you should try to create real-life scenarios. For example, you should bring in all the trading-relating costs because such costs impact your profits and losses.

While backtesting can be a great starting point, it does not allow you to create the sense of thrill or stress, which trading in real-time results in. In real-time, trading can stress out traders and at times they may end up making decisions, which they should not have. Such factors are not considered in backtesting.

That said, backtesting is a great starting point for any trader. It can help him develop a feel for the market. Now that we have explained what backtesting is, let us move on to other aspects.

The Basics of Trading Strategies

Before we explain backtesting, we need to understand the basics of trading strategies. Such strategies comprise the following:

  1. The first step in a trading strategy involves planning, wherein you plan your trades. This requires you to plan which asset you will be trading in and which action you will be taking (buying, selling, etc.)

  2. After you are done with planning, the next step requires you to actually start trading. For this, you need to place and execute your trades.

  3. The final step requires you to examine the results of your trading and take corrective action if needed.

Why Backtesting is Crucial for Traders?

Backtesting is extremely important for traders for these reasons:

1. It allows them to evaluate how effective a strategy can be before implementing it in real time.

2. They can examine the effectiveness of a strategy without risking their real capital.

3. As markets tend to be uncertain, traders can implement backtesting in all sorts of historical scenarios, for example, trending markets and range-bound markets.

4. This allows them to predict how a strategy will perform in all kinds of market scenarios.

Steps to Backtest a Trading Strategy

  • Decide what you want to backtest: The first thing you need to decide is what you would like to backtest. For this, you can pick up a stock, an index, a commodity, or any other asset like an option for backtesting. Remember that the process of backtesting trading strategies remains the same, no matter for which asset class you are backtesting. Having figured out which asset class you would like to backtest for, you should decide which trading strategy you would like to backtest. For example, if you have a strategy based on moving averages, you will have to input a buy signal and a sell signal.

  • Select a historical period: In this step, you will have to decide which historical period you would like to backtest your strategy for. This period will decide which historical prices you will be applying the strategy to. It is important to choose a historical period wisely. Let us say that you are expecting a range-bound market. Then, you need to find a historical period wherein the markets were range-bound. If you pick a historical period wherein the markets did not behave the way you expect them to behave in the future, then the whole purpose of backtesting will stand defeated.

  • Decide whether you want to do manual backtesting or automated backtesting: At this step, you should decide whether you want to perform backtesting manually or you want to use a certain software to backtest. Needless to say, backtesting existed before software programs came into being. Hence, you can perform backtesting manually. However, if you want to use a software for it, you can do so. If you know how to use that software, you can run the program yourself. In case you do not know, you can use a programmer for this purpose.

How to Manually Backtest a Trading Strategy?

A lot of traders feel overwhelmed when they think of manually backtesting a trading strategy. But it is not so difficult after all. To make it easier for you, we have written down the entire process you need to follow to manually backtest a trading strategy.

  • Develop a trading strategy: First, you need to come up with a trading strategy.

  • Find the appropriate trades in the past: Remember backtesting is all about implementing a trading strategy using historical data. So, you should examine historical data from a relevant period and find those trades that suit your trading strategy. For example, if you are following a simple buy and sell strategy, then you need to find on which prices and dates you should have bought a security and on which prices and dates you should have sold it to earn a profit. You can consider as many variables from historical data as you feel necessary for your analysis. For example, you can consider volume, highs, lows, opening prices, closing prices, etc.

  • Develop a trading system: Having examined the data, you can now see all the trades that would have made you money or would have resulted in losses. Moreover, you can now understand how securities’ prices and volumes behave in a market. At this point, you must realise that it is extremely important to make a journal or diary of all these observations. This record will form the core of the trading system that you will develop for your future trades.

Common Challenges Faced in Backtest Trading

Backtesting has its plus points, but it has certain limitations as well. When these limitations are not dealt with properly, it may make it challenging to use backtesting for trading. Wonder what those limitations are? Find them below.

  • Past performance may not accurately predict the future: Backtesting is based on historical data. It is not necessary that a strategy that performed well in the past will work well in the future, too. While backtesting can reveal interesting insights, traders should always be cautious while relying on past performance.

  • Does not consider the emotional aspect of trading: No one can deny that emotions play a huge role in trading. In fact, some traders believe that market movements are more a function of emotions than logic. When we backtest, we cannot consider emotions because those market movements have already happened. If we use a backtested strategy for our future trades, we are assuming that our emotions will not play any role in trading, which is not realistic.

  • Survivorship bias: While backtesting, we only consider those assets that have survived to date. What about those assets that failed? This shows that backtesting paints a rosier picture of historical data than reality would permit. Imagine looking at an old car and thinking that they do not make such nice-looking cars anymore. We can only say this about cars that did not fail and have survived to date.

  • Ignore transaction costs: Often several costs are ignored while performing backtesting. For example, transaction costs, bid-ask spreads, and slippages are ignored during backtesting. The fact is that such costs often eat up a significant portion of a trader’s profit. Therefore, it does not make sense to ignore such costs, as doing so will not paint a realistic picture of trading.

How to Backtest a Strategy Using Software?

Whether you are backtesting a trading strategy manually or using a software, your thought-process should remain the same. We have already explained how to manually backtest a trading strategy. However, if you want to use software for backtesting, consider the following factors.

1. To backtest a strategy using software, you need to first figure out your backtesting strategy. There can be innumerable trading strategies for backtesting. So, the first step requires you to finalise your strategy.

2. Having finalised the strategy, you need to find the right software to execute it. There are many software in the market, for example, Amibroker, MetaTrader 4, ProBacktest, and TradeStation.

3. You should keep two things in mind while backtesting software. One, not all software will provide you with all the features you need. Two, you as a trader may not be comfortable with the pros and cons of all available software. Therefore, picking the right software for backtesting is extremely important.

4. Having chosen a software, you need to install it and get comfortable with it. You may even ask a friend or a colleague who has experience with a backtesting software to help you initially.

Best Practices for Effective Backtesting

At this stage, you must be feeling confident of backtesting your strategy. Keep these best practices in mind while doing so:

  1. Factor in all market scenarios: Suppose you are backtesting a strategy but you are testing it only for a bear market. This strategy will not be able to help you in a bull market. Therefore, you should factor in all sorts of market scenarios while backtesting.

  2. Pick relevant data set for backtesting: You must have heard that apples should not be compared to oranges; apples must be compared only with apples. Suppose you are backtesting for pharmaceutical stocks. You cannot use those findings for trading on telecom stocks. Therefore, you need to pick a relevant data set for backtesting.

  3. Use correct parameters to get realistic results: At times traders do not use all the required parameters while backtesting their strategy. For example, some of them do not include transaction costs. Therefore, it is necessary that you include all the parameters relevant to your trading strategy while backtesting so that you get realistic results.

  4. Do not be overconfident of a profitable strategy: You backtest a dataset to get a profitable strategy. Once you find such a strategy, you should not be overconfident and must not apply it blindly in all situations. Bear in mind that backtesting is based on historical data and the same strategy may not result in profits in real time.

Conclusion

If you have a trading account, you must be thinking of backtesting a strategy. Backtesting is certainly one of the best trading strategies because it allows traders to evaluate a strategy without risking their capital. It provides them with insights into market movements to hone their strategies. That said while trading online, you should not rely only on backtesting. At the end of the day, it is only one of the several indicators or methods to analyse the market. Therefore, you should use a bunch of indicators to make your trading decision.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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Frequently Asked Questions

What is backtesting in trading?

Answer Field

Backtesting refers to evaluating a trading strategy by implementing it on historical data.

How can I backtest a trading strategy effectively?

Answer Field

You need to first develop a trading strategy. Then, you should find appropriate trades in the past and finally develop a trading system to backtest a strategy.

What are the best tools for backtesting trading strategies?

Answer Field

Some of the best tools for backtesting are Amibroker, MetaTrader 4, ProBacktest, and TradeStation.

How do I interpret backtesting results?

Answer Field

You do not have to understand each number from a backtesting report. Instead, you should focus on the results on these parameters: total net profit, maximal drawdown, total trades, and profit trades.

Can I backtest a strategy without programming skills?

Answer Field

Yes, you can backtest a strategy manually. If you want to use software for backtesting but do not know how to use it, you can hire a programmer.

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