What Is Backtesting A Trading Strategy?

Backtesting is considered to be an important tool in a Financial trader’s toolbox, without which they wouldn’t even think of diving into the markets. Think about it, before you buy anything, be it a mobile phone or a car, you would want to check the history of the brand, its features etc. and check if it is worth your money. The same principle applies to trading. But what is backtesting?

In simple words, backtesting a trading strategy is the process of testing a trading hypothesis/strategy on prior time periods. Instead of applying a strategy for the time period forward (to judge performance), which could take years, a trader can simulate his or her trading strategy on relevant past data.

For example, say, a trader wants to test a strategy based on the notion that Internet IPOs outperform the overall market. If you were to test this strategy during the dotcom boom years in the late 90s, the strategy would outperform the market significantly. However, trying the same strategy after the bubble burst would result in dismal returns. The maxim ‘past performance does not necessarily guarantee future returns’ has to be kept into consideration while backtesting a trading strategy.

In this article, we will cover the following topics:

·         Automated backtesting and Manual Backtesting

·         Key Decisions for Backtesting Trading Strategy

·         Typical Backtesting Parameters to Evaluate a Trading System

·         Process of Backtesting

·         Platforms Used for Backtesting

·         Be Aware of Bias

Automated Backtesting and Manual Backtesting

Just like we have manual trading and automated trading, backtesting, too, runs on similar lines. Simply speaking, automated backtesting works on a code which is developed by the user where the trades are automatically placed according to his strategy whereas manual backtesting requires one to study the charts and conditions manually and place the trades according to the rules set by him. If one is good at coding, then automated trading would be of great benefit. However, one needs to keep in mind the current market conditions and tune his strategy and code accordingly to fit these conditions or it may give inaccurate results due to the changing market conditions. We will go through a few concepts in the next section.