How to follow backtesting best practices in trading
Wed Apr 19 2023
In both manual as well as algorithmic trading, backtesting is an essential step when creating a personalized strategy. In this article we're exploring the concept of backtesting in more detail, and how it can be implemented successfully.
In both manual as well as algorithmic trading, backtesting is an essential step when creating a personalized strategy. It entails simulating past trades using historical data and a specific system to determine the potential effectiveness of an investment approach. By analyzing the results of backtesting, traders can gauge the viability of their strategies.
Understanding Backtesting
To assess the validity of your trading concepts, backtesting is a valuable tool. This process involves using historical market data to evaluate the performance of a particular strategy. If the strategy demonstrates promise, it may also be effective in real-time trading situations.
Before embarking on backtesting, it’s important to identify the type of trader you are: discretionary or systematic.
Discretionary traders rely on their own judgment when deciding when to enter and exit positions. This flexible strategy is primarily based on the trader’s interpretation of current conditions, making backtesting less relevant since the approach is not rigidly defined.
On the other hand, systematic trading is more suitable for backtesting. Systematic traders follow a predefined system that dictates when to enter and exit the market. While these traders can control various aspects of the strategy, the system generates the entry and exit signals for them. This trading style is commonly used in algorithmic cryptocurrency trading as well as other asset classes.
Conducting a Backtest for Your Trading Strategy
You can either purchase backtesting software to automate the process or choose to manually backtest your strategy using a spreadsheet. A basic spreadsheet can give you a general idea of the information needed for backtesting. You can include as much data as necessary, along with any additional information you find helpful.
In order to conduct a successful backtest, make sure that:
- Your historical data matches your strategy’s timeframe
- Your exit strategy is well defined and can be easily replicated historically
Analyzing Backtesting Outcomes
Backtesting results offer various metrics, ranging from volatility measures to win-loss ratios. The more detailed your trading journal is regarding relevant setups, the more you can learn from the outcomes. Some traders are particularly meticulous in their backtesting, which is often evident in their results.
It’s also essential to consider optimization. If you’re familiar with backtesting, you’ll understand the difference between backtesting and forward-testing (also known as paper trading).