The Importance Of Backtesting Strategies For Trading

We tend to learn from the past, implement those lessons in the present, and modify them for the future. Backtesting is all about this pattern with a little twist in it. With the backtesting strategy you actually ‘predict’ how some trading strategy would perform in the past.

The strategy can be implemented manually or automatically. Either way will help you to get the metrics that will give you a trading strategy that could be implemented in the present or future market. The final conclusion is on the idea that strategies that produced good results in the past will give positive results in the present and future.

The importance of backtesting strategies for trading

A backtesting strategy is important as you can test your own strategy. You can estimate its profitability and gain confidence in your strategy.

Here we’re diving in deep to discover and understand the importance of backtesting as a time machine of the trading era, and what types of backtesting strategies are out there. We’ll cover the rules, benefits, and risks, and then you can decide how and when to use them.

The backtesting strategy as a time machine

When you get your hands on trading the main goal is to have the best trading strategy without risking any capital. Sometimes this seems impossible but by implementing the proper backtesting strategy you’re actually investing in a ‘time machine’.

You must admit, going back in time sounds very fun, but even this kind of ‘time machine’ has its biases and issues, which you as a good investor must fight off. The risks will always be there, but the main goal is for you to detect them in a timely manner, and dispose of the bigger ones.

Why Backtesting Trading Strategies is Important

Remember that you don’t invest in the backtesting strategy. The challenge with these strategies is to make sense of the data and implement it to your risk-taking insights.

How do you backtest a trading strategy

The backtesting form can depend on who and for what purpose is using it. For example, it can be simple with only a few indicators with very simple loss and profit rules. Also, it can be very complex to use order flow data to automate market-making (basically what high-frequency traders do).

If you want to backtest something you need a trading strategy first. This trading strategy will help you to determine the In and out points for the winning and losing trades. The strategy will more likely give you context, for example, when or if some trades should be taken. Backtesting can be done manually or automatically, let’s check them out individually.

Manual backtesting strategy

Of course, a manual backtesting strategy asks for more hard work. The first thing you need is to develop a trading plan. Take in mind the market, period, profit, etc. The more you make your trading strategy clearer the better the results will come from the backtesting.

After you set your strategy parameters it’s time to define the desired financial market and timeframe. All this data should closely reflect the current market environment.

The next step is to analyze the data that you gathered based on your own strategies. The strategy can be short-term or long-term.  For a short-term strategy, you will need historical data from at least several weeks. A long-term strategy must consist of data from many years.

Automated backtesting strategy

Different software uses different approaches when it comes to backtesting. The main point is choosing the right platform for your backtesting. But we will dive into that later on. Now, let’s see how most of these platforms work:

  • You select the relevant period and financial market.
  • Then you set up the relevant parameters of your trading strategy.
  • You run your backtest strategy.
  • If the backtesting strategy is not good, optimize it.

Frequent mistakes with the backtesting strategies

Nobody is perfect, but we can sure try. While conducting the backtesting there is a possibility that while wishing everything turns out perfectly you’ll make mistakes. Here are a few:

  • Overfitting: People are tempted to look way ahead when they are implementing a backtesting strategy. Ask yourself why you think that the strategy would work. Don’t get a grip on the past and try to do a perfect curve-fitting or misleading given data.
  • You don’t do forward testing: When you are done with backtesting the strategy leave your strategy ‘on the shelf’ for a while. Check up on your strategy regularly to see how the forward tests compare to the backtests. If the forward and backtest are positive then you can start the live trading. A good correlation between backtesting and forward testing is very important for the viability of your trading system.
  • Not using the relevant set of data: You need to set your preferences. For example, if you have a trading strategy for technology stocks, the same strategy may perform poorly while trading manufacturing stocks. It’s best if you use two sets of data. You test several parameters on the first set and check your strategy on the second.

4 best backtesting software

You can find a lot of backtesting software on the internet but that doesn’t mean that all of them will work for you and your backtesting strategy. Some of the listed software require payment, but some have free features if you are on a budget.

Here is a list of the four backtesting software:

1. Composer

Composer is ideal for people who want to be in the trading business, but don’t want to deal with complicated spreadsheets or learn a programming language. This trade automation software will help you create and automate your own advanced trading strategies.

If you want to decide about using the platform, they have neatly prepared tutorials and walkthroughs by quite eminent users. Their app is very accessible, and it’s easy to register. You can navigate and use the platform with ease without specific previous knowledge.

Composer really did make the backtesting strategy an easily achievable goal with their visual editor. The best thing about this platform is that you can sign up for free. You can gain a lot from their free version. For example, you will be able to create your own trading and backtesting strategy, and also you will be able to monitor your strategies in real time.

Trading Chart

2. MetaTrader 5 Strategy Testing

This is another backtesting strategy software that allows testing on multiple currencies. You will have the chance to evaluate a robot’s performance prior to trading in the real world.

MT5 has three testing models from which you can choose. “Open prices only” is for a rough estimation based on bars’ open prices, then we have “1-minute OHLC” for quick trading, and “Every tick” is with the biggest accuracy.

There are a couple of different tabs that need to be navigated here so it’s better if you prepare yourself before you start using this software. First, you need to set the Expert, the Symbol, the Time frame, and the Modelling. After that, you click Start and you can see if the strategy was profitable or not.

3. Forex tester

One more independent software, that is not a trading platform. The Forex tester is a very good option for beginners. That’s why there are beginner tutorials that can find quite in handy if you are new to this.

The basic subscription is free, but if you want data with additional instruments or you want tick data then you will have to upgrade for a better backtesting strategy.

4. Tradingview

This web-based platform gives mostly accurate price charts with real data. Their free plan will allow you to get only one indicator but if you upgrade you will be able to add more.

A good backtesting strategy is a way to learn from our past mistakes

We would all want to know the secret of success, but it turns out it’s not that ‘magical’. The secret includes a lot of data, history, and effort. A backtesting strategy is one of the steps to getting closer to success.

Trading Platform on Laptop

When you have a good backtesting strategy you don’t have the whole solution but the key to it. Include more data so you get a more accurate strategy. Being through enough is never a mistake because you wouldn’t like to lose your time and money.  Following your gut can’t be your only option in the modern digital era. Today everything is data and data is everything. The people in fancy suits are not the only ones that use backtesting to make good trade strategies. Don’t hesitate to dig up the past so you can make a better future for yourself.

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