Backtesting is a way to see how well your strategy or model will perform. It assesses the viability of trading strategy through discovering ways it will work using the historical data. Once the backtesting works, then traders and analysts will have the confidence to apply it forward in their strategy.
This strategy allows traders to simulate their trading strategy with the available historical market data. That way, traders can analyze the possible risk, as well as, the profitability before they risk their actual capital.
A well-conducted backtest with positive results will make traders think that their strategy is fundamentally sound and will give them profits. On the other hand, if the result is bad, then traders will alter or reject the strategy.
Every trading strategy that can be quantified can be backtested. Yet, most traders seek helps from the expertise of a qualified programmer to do it since it involves a programmer coding into the proprietary language within the trading platform.
How to Conduct Backtesting
Ideally, traders should choose the sample data from a relevant time period that reflects the current market condition. That way, the trader will get results that highly representing the current market.
That historical data should involve the representative sample of stocks. Besides, the data should also include companies that went bankrupt or were liquidated or sold. If the investors only include data from historical stocks that still being around today, they will only get artificially high returns.
Backtest should consider all of the trading costs, including the least significant ones. Those costs may add up the course of the backtesting period. Thus, it should always account for these costs.
Meanwhile, the forward performance and out-of-sample testing will provide further confirmation, that includes the system’s effectiveness and the system’s true colors. The correlation between backtesting, out-of-sample and forward performance testing is essential to find the viability from a trading system.