Backtesting

March 27, 2023
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6m

Backtesting is a process used to test selected trading strategies based on historical data in order to examine their effectiveness.

How does backtesting work?

The aim is to evaluate the strength of the strategy and assess its performance if it were applied over a period where historical data is available. Backtesting is commonly used in algorithmic trading, where designed automated strategies are tested before they are implemented in the market.


To start backtesting, archival data is required. Once you have the data, the next step is to define the rules and assumptions of your chosen strategy. For instance, specify the market entry and exit signals, the stop-loss algorithm, and the amount you wish to invest.


Based on these components, the backtesting software processes historical data, and as a result, we have a ready simulation of how the strategy works under the selected assumptions. This is the right moment to analyze the results and consider potential optimizations. Adjustments can be implemented as desired before testing the strategy in the real market.


Backtesting facilitates the early detection of flaws and enables their alterations without financial loss. This way, traders can learn from their mistakes and improve their trading skills without losing their funds.

Backtesting tools

Currently, many platforms offer such a feature, and among the most popular ones are Metatrader, Amibroker, and QuantConnect.


Nevertheless, it is essential to remember that financial markets are unpredictable. When assessing potential investments, it is crucial to be mindful of the current economic situation, regulations, and macroeconomic events that may affect the performance of our strategy.


Types of backtesting

Manual backtesting

Backtesting involves manually searching for trading opportunities and controlling the moment of exit from a particular position. Traders may use tools such as Excel for reporting the results, but it can be tedious and complicated. Manual backtesting is time-consuming, monotonous, and has a high risk of error, although it still has its supporters.

Automated backtesting

Automated backtesting relies on computer code automation of the data analysis and reporting process. This kind of backtesting is more efficient and allows for more optimizations, thus directly influencing the higher chances of success in the real market.

Backtesting with Python code

Traders can utilize backtesting with Python by writing their own backtesting algorithms. This allows for tailored solutions, but it requires programming skills.

Summary

Backtesting is the process of testing trading strategies using historical data to evaluate their effectiveness before execution. The aim is to identify any flaws and correct them without financial loss. Automated backtesting is more efficient and allows for more optimizations, while backtesting with Python offers tailored solutions but requires programming skills.


However, it's important to remember that financial markets are unpredictable, and traders should consider current economic situations, regulations, and macroeconomic events that may impact their strategies' performance.

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