article by CryptoJelleNL
Many new traders build a trading strategy, and usually find out that it does not work along the way of using it. This way of learning the success rate of a strategy can be immensely costly, which is why more experienced traders put their strategies to the test before trading their hard-earned money with it.
In today's article, we dive into one of those testing approaches: backtesting. Read on to learn everything there is to know about this approach, and how you can use it to your advantage!
What is backtesting?
Backtesting is a popular approach where traders analyze the potential performance, accuracy and strike rate of their trading strategy on historical price action. It is often used to test trading strategies, and to get an idea of how it will perform in the present.
These tests are performed either manually, or with backtesting software, and are purely "on paper", meaning that no trading capital is required to backtest a strategy. Backtesting is based on the assumption that a strategy that would have performed well in the past, will likely work well in the future as well. Thus, running a new strategy on historical price action will give you a reasonable idea about the potential success of a strategy.
Nevertheless, it is important to remember that a successful backtest does not guarantee the strategy will be successful in the present as well. Backtesting merely serves as an indication, but can be useful to finetune the strategy and sniff out systematic errors in the strategy before deploying it in the market.
The advantages of backtesting
The popular testing approach has both advantages and drawbacks. On the plus side, you can test wildly different trading strategies objectively, and do not risk any capital in doing so. The outcomes of a backtest provide you with great insight that can be used to further optimise a strategy, allowing you to produce a well-rounded strategy that matches your risk preference, and your expectations.
The disadvantages of backtesting
While there are plenty of positives for backtesting, it is not without drawbacks either. For instance, past data can be reliable, but it does not guarantee future market behaviour. Backtesting can at most be indicative of the potential success of a strategy.
Furthermore, selecting the data to test against can introduce significant bias into the testing process, which would make the entire outcome flawed. If a strategy is tested in a bull market, the backtest can only be considered meaningful if the present market conditions are bullish as well, and conversely for bearish conditions.
What do I need to backtest a strategy?
Regardless of its drawbacks, backtesting a strategy is still a productive activity. It will teach you more about the strategy, and can help you refine it.
Before backtesting a strategy, traders must have a well-defined and systematic trading strategy, with clear rules to follow. Under which conditions do you enter or exit a trade, what is the maximum risk per position, on what timeframe should the strategy be tested, et cetera. In essence, there should not be any wiggle room, but rather a very easy to follow set of rules.
They should also have a clear set of expectations regarding the strategy, on both the level of risk, and the expected return - while also having a solid understanding of the asset they wish to test it against.
To properly backtest, traders should select a dataset that most accurately reflects the current market situation. Testing against very different market conditions may lead to inaccurate results.
Pro Tip: Do not forget to account for fees either!
How To Do Backtesting In Trading?
A backtest generally follows the same, standardised approach. The first step is to define the strategy. As discussed earlier, developing a well-defined strategy is crucial for a successful backtest. Define entry and exit triggers, stop loss and take profit placement, the timeframe to trade at, and other relevant parameters. The clearer the strategy is, the better. Also make sure to define your expectations - regarding the maximum risk and expected return.
The next step is to gather the data. Make sure you have access to the historical market data, and then perform your backtest. This process depends on whether you wish to manually backtest, or use a backtesting tool. Popular charting platform TradingView has a built-in strategy tester, which can be used to backtest trading strategies - although they do require a basic understanding of Pine Script, the platform's native programming language.
Alternatively, traders can manually backtest a strategy by analysing the historical charts and recording the outcomes of each trade that would be taken following the entry conditions.
After this stage, you should have an overview of all the trades taken in the selected timeframe, as well as the outcome of these trades. From here, the next step is to assess the performance of the strategy, by calculating the results and comparing them with the expectations you set out at the start.
The final stage is to draw your conclusions. You may need to make modifications to the strategy, and test it again - or decide to discard the strategy altogether. Alternatively, you may decide the strategy is ready for real-world deployment.
All in all, backtesting is a great approach to strategy building and testing. It can help you learn more about the potential success of a strategy, while also giving you insights into its shortcomings, and flagging points of improvement.
There are many backtesting solutions available to the market, but you can also choose to code your own backtest, or complete the whole process manually. Regardless of the approach you take, make sure you stay as objective as possible - as bias can significantly affect the reliability of your results.
Author's Disclaimer: This article is based on my limited knowledge and experience. It has been written for informational purposes only. It should not be construed as investment advice in any shape or form.
Editor's note: CryptoJelleNL provides insights into the cryptocurrency industry. He has been actively participating in financial markets for over 5 years, primarily focusing on long-term investments in both the stock market and crypto. While he watches the returns of those investments roll in, he writes articles for multiple platforms. From now on, he will be contributing his insights for Alpha Circle as well.
Check out his twitter: twitter.com/cryptojellenl
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