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How To Backtest A Trading Strategy?

BitForex Editor
Jan 22, 2021

One of the most essential skills in improving trading performance is learning how to backtest a trading strategy. Trading revolves around making decisions, and it can be challenging to make decisions, especially when the outcome is unknown. While previous performance does not necessarily guarantee future performance, backtesting is, however, one tool that can boost a trader’s confidence in implementing their system, especially as it allows them to know about the frequency of wins, losses, as well as other data points on a particular strategy.

For most people, learning how to backtest a strategy can be very uninteresting, but the truth remains that it is a necessary tool for achieving trading success. Backtesting is key, especially if you want to have a sense of confidence in your trading strategy. Even if you have a mechanical trading system, human input, or even basic discretion, backtesting still remains important.

What is Backtesting Trading?

As earlier implied, for you to carry out successful backtesting, it is crucial for a trader to have a trading strategy with set rules. The strategy, in this case, could be a manual one, where a trader or traders locates the setup themselves; the trading strategy could also be an automated one where a computer algorithm takes the trades. Both approaches tend to vary when it comes to backtesting.

When learning the process involved in backtesting a trading strategy manually, a trader would have to go back in history to locate all of the trades that have fit their trading strategy before then proceeding to record the data in a journal. With this information, the trader can easily see the historical wins and losses, including the largest run-ups and drawdowns in the account, as well as the consecutive win to loss ratio amongst numerous other data points. Knowledge of this gives the trader confidence in how efficient the system is and whether to trade it live.

The Essence Of Trading Strategy Backtesting

It is necessary to note that trading strategy backtesting is an essential aspect of building your trading approach. The fact remains that backtesting is only the preliminary aspect, as the main step is to put your strategy to the test. The primary aim of backtesting is to show that you have good trade ideas. If your Forex strategy is efficient, it will give you the confidence to forge ahead when the next trade signal shows up. This means that you will be capable of dealing with the emotional side of trading, which is one of the biggest hurdles to conquer

Irrespective of what your trading rules are, you can easily make use of any backtesting technique or software to test the efficiency of your trading strategy. The truth remains that knowing how backtesting a trading strategy can positively help your forex results.

How Backtesting A Trading Strategy is Done?

Irrespective of whether you are learning to backtest a stock strategy or learning how to backtest a forex trading strategy, it is essential to learn how to backtest a trading strategy through the use of “Excel.”

Trading is more than crunching data, it also involves knowing and recognizing patterns. The more you are able to build your memory bank of what you should be trading as well as what you shouldn’t be trading, the more you are going to be able to make better decisions in the future. One important factor to take into account is that in order to start backtesting, it is pertinent for a trader, first of all, to have a trading strategy to test.

How To Build A Trading Strategy?

There are various ways of building a trading strategy; however, the most essential and fundamental components should include the following inputs:

Which instrument will you trade on?

 It is essential to identify the markets and symbols you want to trade on. A strategy that may be effective on indices might not function at all on Forex markets. Though the markets you choose to trade on doesn’t matter, it is, however, important to have a focus. For example, various Forex traders would choose to first of all tart with major currency pairs against the US dollar.

Which time frames will you trade on?

Backtesting a strategy on the daily chart and then attempting to trade it on an hourly chart would most likely lead to very different results. This is why it is necessary to identify the time frame you plan to trade on.

What tools will you use to buy or sell?

When traders make a certain trading decision, they tend to make use of different tools to help them. These tools could either be from technical or fundamental analysis, with the former being the most prominent. In technical analysis, traders make use of trading indicators and chart patterns to make trading decisions on when to purchase or sell. Defining your tool is important in backtesting as it helps you to know what you are looking for.

How will you risk manage your trades?

One key factor to long-term trading success is “risk management.” How much are you willing to risk per trade? Where will you put your stop loss and take profit? When going through historical trades, it is essential to have this information ready so as to make the backtesting results more meaningful.

Possible Pitfall Of Backtesting A Trading Strategy

For backtesting to provide efficient results, it is necessary for traders to develop their strategies and also test them in good faith while still avoiding bias as much as possible. In context, this means that the strategy should be developed without having to rely on the information used in backtesting. That can prove difficult as traders build strategies based on historical data. They must also be strict about testing with a variety of data sets from the ones they train their models on, as the backtest will most likely produce glowing results, which mean nothing.

In essence, trading strategy backtesting requires the manipulation of backtesting parameters in other to get the most efficient promising trading strategy. This will aid you in maximizing your profits on your trading ideas. Irrespective of how you choose to put it, backtesting remains essential for knowing the viability of a trading strategy.

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