Backtesting is the process of evaluating how well a trading strategy or analytical method works based on historical data. This is a key factor in developing an effective trading strategy. There are endless possibilities in strategy, and small changes can change the outcome. This is why backtesting is important because it shows whether certain parameters perform better than others.
Backtesting requires a trading strategy. So it is called backtest trading. At a minimum, trading strategies help define entry and exit points for both winning and losing trades, as well as position size. Additionally, trading strategies often provide context such as: Defining if and when to trade. For example, if the price is above or below the moving average, or just his first hour of the day.
Backtesting can be a simple or complex process and traders can use either automated or manual testing. The former requires automated software that looks for trades that meet the criteria of the strategy and sums the winning and losing trades to indicate whether the strategy is profitable over a period of time. Manual backtesting refers to the process by which a trader analyzes previous trades based on a strategy and totals the results himself.
How to Backtest a Trading Strategy
There are several steps to manually backtesting a trading strategy or trading model. Backtesting requires historical data showing past price movements of a particular asset from trading charts. For backtesting, traders typically need weeks of historical data for strategies whose trading is short-term in nature. Many years of historical data may be required to test long-term strategies.
The basic steps in performing a manual backtest are:
- Define strategy parameters. Backtesting takes practice, so there is no need to risk depositing live money.
- Specifies the financial market and chart the timeframe on which the strategy will be tested. For example, will you be focusing on a single stock or currency pair, or different markets, and whether you want to collect results over a period of time, weekly, monthly, or yearly? A long or ten-year historical period. Each selection provides different results and information.
- Initiate a transaction search. You can go back in time and look for deals from a year, a month, or a week ago, depending on how far back you want to go.
- Analyze price charts for entry and exit signals. This can be done until all trades on the chart to date have been identified and marked or noted.
- To find the total profit, record all the transactions and add them together. They must include both winning and losing trades
Backtest trading can show how a trading strategy has performed in the past, but it cannot guarantee the future performance of the strategy. This is why backtesting can be a useful tool. But you shouldn’t rely solely on it. Traders can also “forward test” their strategy on live market conditions to see if it works in real-time.