What is Backtesting?
The stock market works on both data and sentiment. Many novice traders make decisions based on quick tips or have emotional biases while trading. Relying only upon emotional or tip-based decisions can be harmful in long run.
It is beneficial to use tested trading methods, which can save you from losses. In the end, traders are taking a bet on their money without being sure of its worth. This is where backtesting comes to the rescue. This article highlights the concept of backtesting, its comparison with forward performance testing, and why it matters.
Meaning and Definition of Backtesting
Backtesting means the process of testing a trading strategy on historical data to assess its accuracy. Technical traders often use this to test the trading strategies to find how it is likely to perform in the real market. Though, no funds are invested in reality. Backtesting is based on the phenomenon that, the strategy which performed well in the past, is expected to work well in the future and vice versa.
Before backtesting, investors look into some essential elements. A clear picture of trading strategy, expected risk and profit of the asset, historical data of the financial assets, among other parameters. The trader must be aware of what they want to find out when backtesting a strategy and its expected outcomes.
Additionally, traders decide on the level of risk and expected return. Data and time-frame are of utmost importance when backtesting. Moreover, the trader should select the period which reflects the current market situation. Misleading data or inappropriate time selection may lead to inaccurate results.
Backtesting can be done either manually or by software. To manually backtest, traders first define the financial asset and sample time frame to be tested. Then, they can start observing and analyzing trades based on the strategy in the time frame selected. A trader can observe price charts and gross and net returns from the recorded trades.
Example of backtesting
For example, Chirag wants to backtest the strategy of going short when short-term MA falls below the long-term MA, as he thinks this strategy leads to 1.5x more profit. First, he will take a sample time. Then, he will get the price data from the sample time and calculate moving averages. Next, he will sell the stock whenever short-term MA falls below the long-term MA. Then, he can plot the returns, draw a curve and analyze the result. From the result he gets, he can decide whether to go ahead or reject the strategy.
Backtesting using software differs among various software options. Though, these are the common steps. First, traders feed the historic data including relevant financial assets and periods. Next, he needs to set parameters of trading strategy which can be initial capital, size of the portfolio, benchmark, profit level, stop loss instructions, and so on. Then, he can run a backtest. Most of the software provides strategy optimization features, too.
Backtesting vs. Forward Performance Testing
Forward performance testing is another important method that plays a crucial role while developing a trading strategy. It is also called ‘Paper trading’ and ‘Out-of-sample trading’. Here, all trades occur only on paper. In forward performance testing, all trade transactions are recorded along with profits and losses associated with the trading system. Though, no actual trades are implemented.
To accurately evaluate the trading strategy, forward performance testing must follow the system’s logic. Additionally, all the trades that would have happened according to the system’s logic must be documented strictly.
Backtesting lacks live data which is a part of forward testing. While backtesting helps in interpreting how the trading strategy would have behaved in the past, forward testing informs the traders how it would perform now.
A similarity between both of these methods is that a trader does not have to risk their capital while performing it.
Why does Backtesting Matter?
Backtesting helps in interpreting the past. It provides statistical feedback for the trading system. It also helps in quantifying risk and return which leads to efficient trade. Traders can use backtesting as a way to compare multiple strategies before risking their capital.
When the backtesting is carried out properly and gives positive results, the strategy is believed to be fundamentally strong. This means a trader can confidently move ahead as the strategy is likely to give positive results when they execute it.
However, if the backtesting is carried out properly but falls short on the result, traders can reject or alter the strategy.
While there isn’t a distinctive test that can predict future performance. backtesting proves to be an efficient way in the trading system since it allows traders to test the strategies before actually executing them in the real market. Though, it can mislead the trader if conducted with bias. Even if it is conducted properly, using backtest in isolation may not give efficient results. Thus, backtest is better used with other parameters to assess the viability of the strategies.
Frequently Asked Questions Expand All
To perform a backtest, first, you need to collect required historical data and feed it into the software. After that, you need to set parameters of trading strategy which can be initial capital, size of portfolio, benchmark, profit level, stop loss instructions, and so on. Then you can backtest the data set using above mentioned data.
Backtesting is used for time series because it is sequence-based and provides close results to real-life conditions. Another reason is random validation does not work for time series and backtest does not use cross-validation.
Though backtesting is an efficient way to test the trading strategy, there is no guarantee that it will work. Past performance does not guarantee future results. There does not exist any test that exactly tells how the trading system will behave.