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In real life, it isn’t possible to backtest your decisions, or we could avoid making all the stupid mistakes we made. But when you are a trader, backtesting trading strategy is an option.
It allows you to quantify the risks and returns of your decisions, analyse the history and predict the future behaviour of your plan. Traders use backtesting software for this purpose. This article is a step-by-step guide on how to backtest a trading strategy, the best backtesting strategy, and its importance.
Key Takeaways
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Analysing how a trading plan would have worked using past market data can be explained as backtesting.
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The effectiveness of the strategy can be tested either manually or by using software.
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To ensure the best results, use real, complete data that reflects costs and market changes.
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With backtesting, traders can improve their plan and invest with confidence.
What is Backtesting?
Backtesting is vital for traders and analysts as it allows them to analyse trading strategy potential by applying it to historical data. It helps them to calculate risks, simulate traders, and evaluate profits without investing any real money. With a positive backtest, investors are more confident about putting their money while with a negative backtest, they get a chance for reassessment before investing.
What is a Backtesting Trading Strategy?
A backtesting trading strategy simply means checking how your trading plan would have worked in the past using real market data. The idea is that if your strategy performed well before, it might also work in the future. Traders use backtesting to see the possible risks and returns of their approach without risking real money. If the results are good, it builds confidence; if not, the trader can adjust or change the plan.
Backtesting uses historical data to predict future performance and helps you make smarter, data-backed decisions instead of random guesses. It’s especially helpful for beginners who want to test ideas safely. You can do backtesting in two ways, manually, by analysing past charts and trades yourself, or automatically, using backtesting software that runs tests quickly and accurately. In short, backtesting helps traders understand whether their strategy is practical, profitable, and worth using in real markets.
Steps for Backtesting Trading Strategy
Manual backtesting involves the following steps.
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• Backtesting can be performed of any quantifiable trading strategy. Traders build a trading strategy around market conditions, trading period, risk level, profit target, and general entry and exit points. Once you have an in-depth trading strategy with defined parameters, you can apply it to backtest.
Testing an unclear trading strategy will give clouded results.
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Traders should first choose the asset and market they want to test. For example the stock market for shares or the forex market for currency trading.
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Since strategies react differently over time, it’s important to pick a timeframe that closely matches current market conditions for accurate results.
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During backtesting, traders check and compare the results to see whether the strategy performs as expected.
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If the test shows good results, it means the strategy is working well. If it doesn’t, traders can use the findings to adjust and improve their plan.
The Benefits of Backtesting
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One of the biggest benefits of backtesting is that it allows you to try a wide range of trading strategies without investing any real capital.
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It provides you with a test, optimise and re-set cycle that enables you to fine tune any strategy that you can think can deliver desired results.
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It allows you to develop and adjust strategies that are in accordance with your loss and profit capacity.
Backtesting Trading Strategy Using a Software Tool
Nowadays, using backtesting software has simplified and optimised the process. Most of these tools perform on user inputs and lets you tweak the system to adjust to your testing requirements. It involves the steps below.
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Select the market that represents the asset and the period.
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Set relevant parameters for the test, like initial capital, portfolio size, benchmark, profit level, stop-loss level, etc.
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Run the backtest.
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You will get either success or failure. In case of failure, optimise your strategy.
Key Factors to Consider When Backtesting
There are a few factors to consider while backtesting to improve the accuracy of your test.
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The first is to find a data set from a relevant time period and duration that accurately reflects various market conditions. This way one can assure that the test results are based on solid research.
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The backtesting data should represent all stocks, including bankrupt or liquidated stocks for the most accurate results. Excluding such stocks will result in significantly high results and may impact the accuracy of the outcome.
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The testing should include all trading costs. All these costs can add up during the testing period and affect actual profitability.
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Lastly, testing your strategy outside of the data set and forward testing further confirm the suitability of the strategy in a real-world scenario. Your backtesting, out-of-sample, and forward-testing results should conform for the best trading strategy.
Difference Between Backtesting and Paper Trading
Traders use backtesting and forward performance testing to check the relevancy of the trading strategy. Forward performance testing, or the paper trading method, uses a simulated trading environment that reflects a live market and data. Traders use paper to write down the steps of the trade, including entry and exit, as well as profit and loss.
If the backtesting and forward performance testing produce the same results, it means you have a solid trading plan.
Backtesting vs Scenario Testing
Scenario testing will simulate various hypothetical data that reflect changes in the values of portfolio security and other key factors like changes in interest rates.
Traders use scenario testing to evaluate changes in the portfolio’s value against unfavourable market conditions. Unlike backtesting which uses real data, scenario testing uses hypothetical data to examine worst-case scenarios.
Why is Backtesting Important?
Backtesting provides several critical statistical feedback about the strategy.
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Net profit and loss or the net percentage of gain or loss
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Percentage measure of maximum upside or downside of average gains or losses
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Exposure to the market as ratio of the capital invested
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Win-to-losses ratio
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Percentage of risk-adjusted returns
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Percentage of annualised returns
Pitfalls of Backtesting
Backtesting can provide meaningful results when tested against an unbiased data, meaning the trader must build a strategy independent of test data. However, it is easier said than done because traders usually develop strategies based on historical data. Hence while backtesting, it is vital to test the strategy against different data sets to produce more accurate results.
Traders must also avoid the mistake of data dredging.
Data dredging refers to testing multiple hypothetical strategies against the same data set. It can lead to false hypotheses when an invalid test strategy may also produce success by chance which will fail in real time. It can be a costly mistake if you are unaware.
One way to avoid data dredging is to test a plan against relevant in-sample data and then check it out with a different data set or out-of-sample data set. If both in-sample and out-of-sample tests produce the same results then the strategy is proven to be valid.
Conclusion
Backtesting is a simple yet powerful way to test how a trading strategy would have performed in the past using real historical data. It allows traders to check whether their plan is suitable and effective before putting real money at risk. By studying past market movements, traders can see how their strategy might respond to different situations and market trends.
One of the biggest benefits of backtesting is that it helps traders measure potential risks and returns clearly. It also allows them to fine-tune their trading plan by spotting what works and what doesn’t. Since it uses past data, backtesting provides a safe and practical way to learn, test, and improve strategies without losing money. It builds confidence and encourages smarter decision-making based on data rather than guesswork.
However, it’s important to remember that even a successful backtest doesn’t guarantee the same results in the future. Market conditions can change, and unexpected events may affect performance. That’s why combining backtesting with other testing methods, such as forward testing or paper trading, gives a more complete and reliable understanding of how well a strategy might perform in real trading situations.