Backtesting is one of the most common concepts in finance. It involves evaluating the accuracy of a predictive model using historical data. But does it offer the pinpoint accuracy needed to make profits, or is it another time-waster?
Backtesting is not a waste of time, as it helps you develop the skills needed to identify the best trading strategies, test their accuracy without risking actual cash, and develops confidence. However, since past trends may not repeat in the future, it’s best not to overly rely on backtesting results.
Read on for more information on what backtesting involves, how to do it, and why you should apply it in trading.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Is Backtesting?
Backtesting is one of the most common concepts in finance. According to the Corporate Finance Institute, it involves assessing the effectiveness of a trading strategy using past data. In other words, traders use historical data to determine if a given strategy is profitable.
These investors may apply those strategies in real-life scenarios, depending on the outcomes. A properly executed perfect provides an assurance that a given strategy can generate either positive or negative returns on investment in a live trading environment.
Notably, if the results show that the chosen strategy generates losses, the trader may discard or modify it. Conversely, if it promises profits, the trader may accept it.
However, most analysts agree that you should consider the market conditions at the time for which the historical data was obtained. Market conditions tend to change with time, so the results may vary significantly if the same strategy is employed in real-time.
How Does Backtesting Work?
As previously mentioned, backtesting involves selecting a trading strategy and applying it to historical data to gauge its profitability.
For example, if you’re a trader and decide to backtest a moving average model, you might look at how market prices moved in the past and compare the model’s prediction with the historical prices.
If the model has a high predictive value, you may use it to predict other aspects, like the given firm’s net income, volatility, returns on assets, returns on equity, to mention but a few. However, if the model does not predict historical data well, you may decide to modify it.
Alternatively, you may choose another model and backtest it.
Ways of Backtesting a Strategy
If you plan to check the market using the past five years’ data, here is how you can do it:
Manual Backtesting
This method involves compiling market data and manually checking charts to recognize previous patterns. The pros of using this approach include:
- You learn to spot market trends.
- You can quickly identify your strategy’s strengths and weaknesses.
- Helps you build confidence in trading.
On the other hand, its cons include:
- Manual backtesting is challenging to learn and master and may take years or months to become a pro.
- It’s susceptible to biases.
Automated Backtesting
Automated backtesting software has become commonplace among financial analysts and traders. Using these programs is relatively more straightforward as you simply feed the application the data and wait for it to test your strategy.
However, you may need some programming and coding skills to use some of these tools.
The pros of automated backtesting include:
- A quicker way of checking if a strategy is profitable.
- Eliminates human bias.
- Precise and accurate.
Its cons include:
- You might not spot market patterns.
- Some require programming knowledge.
- Most of the applications are expensive.
For more information on backtesting, I recommend that you read The Book of Back-Tests: Trading Objectively by Sofien Kaabar from Amazon.com. It uses simple language and comes with introductory coding to make your learning experience enjoyable.
Reasons To Backtest Your Trading Strategies
There are several reasons to use backtesting before trading live. Some of the pros of backtesting include:
Backtesting Allows You to Test If Your Strategy Works
Backtesting is one of the ways to test a strategy without losing your hard-earned cash. Instead of using real-time data, which requires spending, you simply collect historical data and objectively confirm whether your plan can generate profits or losses.
You can use the same dataset to test different strategies across various markets within a given timeframe. Besides, you can check if your trading plan has a reasonable drawdown to trade in a live market confidently.
Although the past isn’t a sure-fire predictor of the future or at least a consistently reliable indicator, it provides insights into what to expect during market cycles, like high volatility, flash-crash, or reversing periods.
As a result, you can use past data to make more informed trading decisions.
Backtesting Trains Your RAS
Let me pose a question that may seem unrelated for a moment. Have you ever thought of why you immediately shift your attention to someone when they call you from a distance, regardless of all the noise in your immediate surroundings?
The answer lies in the reticular activating system (RAS), the part of the brain that filters out the noise so that you only get the necessary details, which also can happen in the stock market.
Most notably, it’s critical for traders to develop the ability to tell if a strategy can work within minutes of checking the performance of the model used in backtesting – undoubtedly, you wouldn’t want to spend weeks or months interpreting the results.
Through the repeated practice of backtesting, you develop the talent to recognize trading risks and opportunities on charts.
Once you can recognize patterns, interpret the most important details, and differentiate between buy and sell signals, it becomes easier to trade without procrastinating. Arguably, you wouldn’t want to learn the ropes using live money. Instead, backtesting allows you to master trends and become more informed on the best decisions to make when the market exhibits specific patterns.
Backtesting Helps Optimize a Trading Strategy
Did you know that your traits determine the type of strategy and level of loss you can tolerate?
For instance, if you’re a risk-averse type of person, you’re highly likely to be uncomfortable investing more of your cash, mainly due to the fear of possibly losing all of it. On the other hand, if you’re a risk-seeker, you may invest more with the expectation to make either high profits or losses.
You may wonder, “How does this relate to backtesting?”
With backtesting, you can test different strategies and predict the losses or gains you’d make in different cycles. Armed with such information, you may pick the one that balances between the profit you’d like to make and the amount you’re comfortable investing.
Would you pick a strategy that may earn you a 120% profit but also has the potential to cause a 30% loss if things don’t go well?
Alternatively, would you prefer one that returns 60% but would only result in a 5% loss in the worst-case scenario? Depending on your risk appetite, you might select either after backtesting them – you don’t have to lose your money to pick the optimal approach.
With Backtesting, You Learn How to Generate Trade Ideas
Backtesting is one of the ways to explore your creativity by devising different trading ideas and strategies. For example, you may obtain some insights while testing different strategies and use them to discover new, more effective, and profitable approaches.
The most important thing here is never to underestimate a given strategy, including the one you’ve recently thought of trying out. I highly encourage you to try it out instead of hesitating about it.
After all, you’d just need historical data, so you don’t have to spend cash.
Backtesting Allows You to Develop Sincere Confidence
Repeated backtesting comes in handy by helping you develop the confidence needed to make trading decisions. By practicing this method, you can easily identify some of the strategies that may make losses initially but reverse the trend and become profitable after that.
With such insights, you can confidently decide to hold some trades even when their prices are declining, wait for the market conditions to improve, and sell when the prices are more favorable.
Caveat: Although backtesting comes with the pros I’ve mentioned, it’s crucial to note that past trends may not repeat in the future, so there’s a chance that some strategies that succeeded in the past may fail in the present.
Therefore, it’s best to combine backtesting results with other investment methods, like fundamental and sentimental analysis, to develop more comprehensive trading strategies.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
- Best Trading Courses You Can Take For Free (or at extremely low cost): I reviewed 30+ trading courses to recommend you the best resource, and found Trading Strategies in Emerging Markets Specialization on Coursera to beat every other course on the market. Plus, if you complete this course within 7 days, it will cost you nothing and will be absolutely free! Click Here To Sign Up Today! (If you don’t find this course valuable, you can cancel anytime within the 7 days trial period and pay nothing.)
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Conclusion
Despite the claim that past prices don’t predict future performance, backtesting remains one of the most common tools that financial and investment analysts use. It helps you develop vital skills, like the ability to develop new trading strategies, helps you assess strategies without risking your cash, and can help you identify the most appropriate approaches to trading, depending on your traits.
That said, my two cents is that combining backtesting with other methods that use recent data, such as sentimental analysis, helps develop more profitable trading plans. In other words, it’s critical to combine different tools in your trading kit for increasing your probability of making profit in financial markets.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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