Investing is all about strategy – when do you start, how to get started, where should you invest your money. In 2021, you can get a date, a ride or your groceries with the swipe of a smartphone screen. Investing is no different. If you can automate your bills, why not your investments? It’s just as easy.
Thanks to technology, you have seemingly endless options when deciding where or what to invest, and that can be overwhelming. In the same vein, you can study and be informed of certain market trends to see the performance of a trade. This is where backtesting comes into play, and we’ll discuss whether it is a viable investment strategy.
So, what is it?
Backtesting is a tool that you (as a trader or investor) can use when exploring new markets and strategies. It can provide some valuable feedback based on data and tell you whether your initial idea was valid.
The underlying theory is that any strategy that worked well in the past is likely to work well in the future, and conversely, any strategy that performed poorly in the past is likely to perform poorly in the future.
Some common backtesting measures include:
- Net Profit/Loss
- Return: The total return of the portfolio over a given time frame
- Risk-Adjusted Return: The return of the portfolio adjusted for a level of risk
- Market Exposure: the degree of exposure to different segments of the market
- Volatility: The dispersion of returns on the portfolio
The importance of Backtesting Trading Strategies
You might be wondering: “Why do I want to backtest my trading strategy, especially since my investments have been sound decisions so far?”
Here’s why: backtesting your trading strategy tells you whether you have an edge in the market without risking any real money. If your trading strategy works, it gives you the confidence to stick to it. In short,
If you can define it, you can backtest it.
If you can backtest it, you can trade it.
If you can trade it, you can make money from it.
10 Rules For Backtesting Trading Strategies
- Don’t test a strategy developed during a bear market in a bull market.
- Take into account the universe in which backtesting occurred. Don’t test a strategy developed with a small universe in a large universe.
- Never test a strategy developed with low volatility in high volatility. Traders should seek to keep volatility low to reduce risk and enable easier transition in and out of a given stock.
- The average number of bars held is also very important to watch when developing a trading system.
- Exposure can be a double-edged sword. High exposure can lead to higher gains or conversely, high losses and low exposure can lead to lower gains or losses.
- The average-gain/loss statistic, combined with the wins-to-losses ratio, can be useful for determining optimal position sizing and money management.
- It is important not only to look at the overall annualized return but also to take into account the increased or decreased risk.
- Don’t test a strategy developed with custom commission amounts, round lot sizes, tick sizes, margin requirements, interest rates, slippage assumptions, position-sizing rules, same-bar exit rules, trailing stop settings and much more in standard settings used by most other people who trade the same instruments you trade and use the same broker you use.
- When you over-optimize your strategy, it can become very hard to understand. This means that if you need to change it, or if you want to try something different, it can be very hard to understand what you are doing.
- Sometimes, the market changes, and what used to work before may not be applicable now. If you want to be a successful trader, you must adapt to the changing market conditions.
Concerns with backtesting
Backtesting is not always the most accurate way to gauge the effectiveness of a given trading system. The more you examine the process of backtesting, the more flaws are exposed. Here are three of those flaws:
Backtesting becomes a game
With conventional back-testing software, you can buy and sell with one mouse click, move forward or backward in time as fast as you want. Your mistakes while backtesting will have no effect on your income and your trading account and, therefore, traders tend to approach live trading too sloppy after extended periods of backtesting.
If you are a trend trader, your trading strategy performs poorly in range bound markets and you might not get a single trade for weeks if markets keep on raging. While back-testing, this is no big issue; you can just fast forward a few weeks until volatility picks up and markets start trending again.
Discipline, ‘sitting on your hands’ and patiently waiting for setups is a key characteristic of professional traders and what separates them from impulsive and consistently losing amateurs. Cherry-picking when back-testing is easy, but this is not how trading works.
Lacks real-time market volatility
A key factor for the success of a trader is the ability to avoid premature and knee-jerk decisions; watching prices move up and down in real time (with money on the line) creates anxiety and often leads to impulsive and emotional decisions. Backtesting eliminates emotionally caused impulsive trading decisions.
If you want to make back-testing as valuable as possible, the best you can do for yourself is to test as much as 1 or 2 years of historical data and replay price in real-time. Once you’ve tested 1 or 2 years of data you should be able to judge whether your system has a promising outlook or not. Then it’s time to apply it to live markets.
Backtesting is one of the most important aspects of developing a trading system. If created and interpreted properly, it can help traders optimise and improve their strategies, find any technical or theoretical flaws, as well as gain confidence in their strategy before applying it to the real-world markets.