Backtesting concept

A Quick-Start Guide to Backtesting Trading Strategies

Before entering the foreign exchange (forex) market, you have to prepare a strategy that will support you through your journey. If you wish to know the effectiveness of your chosen strategy, then you can do a process known as backtesting.

As a trader, it will be best for you to begin trading with a solid strategy that you’ll abide to with every trade. This can help you keep better track of your progress as well what you might need to remedy along the way. Regardless, finding the perfect strategy to use throughout your journey can prove to be a hard task to accomplish. There are numerous strategies you can choose from as well as customize to meet your own needs.

There might not be a way to guarantee that you’re strategy will work 100%, but there is still a process that can help you check its efficiency. We’ll now be telling you about the process amply named backtesting.

backtesting trading strategies infographic

What is Backtesting

Backtesting is the known process of testing the efficiency of a trading strategy on relevant historical data. This is to ensure that it’s possible for you to execute before you risk any of your capital. A simulation of the strategy being used over a certain period of time can be initiated. You can then analyze the results for the levels of profitability and risk.

If the result met your set criteria and deem it favorable, you can have some degree of confidence that the strategy is bound to generate profits. However, if the results were less satisfactory, you can choose to modify the strategy until you’re able to optimize it to reach the desired results. In the chance that you tweaked the strategy but still don’t receive the desired results; you can scrap it all-together.

It’s important to keep in mind that when choosing the right strategy, you must have back-up plans. The first might not be the best for you; if that happens, you have to be prepared to replace it.

Backtesting is also considered to be an integral part of effective trading system development. It is normally accomplished by reconstructing with historical data – trades that would have occurred in the past as it follow rules set by a chosen strategy.

Traders use backtesting with the belief that any strategy able to work well in past will also likely work well in the future. Conversely, a strategy that didn’t deliver satisfactory results in the past will most likely perform poorly in the future.

Read more about the things you should remember when backtesting.

Using Backtesting Software

Computer backtesting can provide with another way for you to back test a trading strategy. There are various trading platforms today that will provide you with the opportunity to create a trading model which utilizes technical indicators to establish a predetermined set of rules. The criteria used to determine the rules are based on historical data points. This will allow you to see whether the strategy worked well in the past.

Data and Tools Needed for Backtesting

You can gather plenty of valuable statistical feedback about a system through the use of backtesting. Some of these statistics include, but are not limited to:

  • Annualized return: percentage return over a year
  • Averages: percentage average gain and average loss, average bars held
  • Exposure: percentage of invested capital (amount exposed to the market)
  • Net profit or loss: net percentage gained or lost
  • Ratios: wins-to-losses ratio
  • Risk-adjusted return: percentage return as a function of risk
  • Volatility measures: maximum upside and downside percentage

There are typically two important screens found in backtesting software. The first screen will allow the trader to customize the settings for backtesting, such as time period and commission costs. The second screen shows the actual backtesting results report. You can find the statistics we mentioned above in this report.

Most trading software will normally have the same elements. There are some high-end software programs which also have the ability to perform automatic position sizing, optimization, and other more advanced futures.

Computer screen showing charts with the word backtesting in the middle

2 Types of Backtesting

Automated Forex Backtesting

When performing automated backtesting, you must first create a program that will automatically open and close trades in your place. Such programs are usually based on a technical algorithm meant to open and manage the trades for you when certain technical conditions are met.

If you decide to go through with this way of trading, you must first build your own or buy it. Using this method can take too long to finish, or be too expensive to buy. Aside from this, nothing is added to your trading experience which can be a hindrance if you’re serious in becoming a successful trader.

An example of an automated backtesting tool is the MT4 strategy tester. It has a built-in backtesting system which can be found within the MetaTrader 4 platform.

It offers language and graphical user interface which you can use to efficiently build your system on the platform. There’s also the option to use an Application Program Interface or API to code a customized system.

Pros

  • You can gain profits even if you’re sleeping.
  • You stay emotionally detached from trading.
  • The testing phase will ensure that you don’t lose any money.
  • You can leverage on a copy trading service to help make more money.

Cons

  • It can take too long to create your own program.
  • Even one misplaced comma in the code can cost you your entire account. You should perform extensive testing first.
  • You must understand the entire parameters of the trading system to identify when it stops working.
  • It might be too expensive to buy the program.
  • It’s not guaranteed to work in live trading and must be forward tested first.
  • It will not add anything to your trading experience.

Learn more about how to recover from a trading loss.

Businessmen studying graphs and data in computer screen and handheld

Manual Forex Backtesting

Manual backtesting involves manually scrolling the chart on your trading platform to a previous period before manually moving forwards, bar by bar, using the “forward” arrow on your keyboard.

Even if you do wish to partake in automated backtesting, it’s still highly recommended to start in manual backtesting. This method is easier to start with compared to the one discussed above. You will also have a better feel of the system. However, if you are well-versed in programming or is an engineer to begin with, you may be better suited to automated trading.

Using the manual backtesting method can be a time consuming task, but is a true and tried method. Despite this, it does not mean that there are no drawbacks. Two of the drawbacks of using manual backtesting include the lack of efficiency, as well as a greater possibility of you making an error.

This method will give you the opportunity to gauge whether the trade idea you have chosen is viable. You will be able to scroll through historical data to see for yourself whether your trade ideas will work. But having identified the variable you would want to test extensively, you might be better off using an automated process.

You first have to find charting software that will be easy and convenient to use before starting the manual backtesting. It will also work best in your favor if you have five or ten years’ worth of available data.

Pros

  • You can understand the trading system better since you’re the one executing every single trade.
  • Having experience in manual backtesting can help you in improving the system or if you decide to create your own automated version later.
  • There is no amount of experience required to perform backtesting.
  • It will be able to simulate live trading mechanics such as entering/exiting trades, using proper risk, etc.
  • You will not be risking any of your actual money.

Cons

  • Manual backtesting can be a time consuming task to perform.
  • You also have to perform forward tests since it can’t be guaranteed that it will work in live trading.
  • You need to be able to handle and accept the drawdowns that you might face when using the system.
  • There are a set of rules that you must follow during the testing. You can’t keep changing these rules in the middle of test since it will deliver inaccurate results.

Man studies printed graphs and chart on the table with other data overlay

Conclusion

When deciding to develop a trading system, backtesting is one of the most important aspects you have to consider. If you’re able to create and interpret properly, it can greatly help you optimize and improve your trading strategies, and identify any possible flaws in the strategy.

You’re given two options for conducting backtests on your trading strategies. First, identify which one will be best for you before proceeding. It’s better for you to choose one and be an expert on that method.

Don’t be afraid to find out how your ideas and strategies might perform, you can only learn more from the data you gather from such tests. Always have a back-up plan or strategy when identifying the best strategy for you. When you find the best strategy that will meet your criteria, you can set out for the actual live trading.

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