What is Backtesting in Trading?
Backtesting is a tool to help you design and implement your trading strategy. Backtesting consists of testing the effectiveness of a trading strategy with historical data before implementing it; in this way you can assess the opportunities or threats of the chosen strategy and correct what is necessary.
Importance of backtesting for traders
Backtesting is important in that it is a tool to help minimize errors and maximize opportunities. Backtesting will allow you to:
- Test and see if your strategy can work or not. In this way you will be able to estimate and evaluate the performance of a strategy without risking money since you are not going to carry it out in a real way.
- Identify and correct possible errors before you actually launch the strategy.
- Assess the risk involved in the operation.
- To have more security and confidence when it comes to implementing this strategy.
Is backtesting really effective?
Yes, to the extent that it helps you to minimize errors and correct aspects that can contribute to your strategy being more or less successful.
In any case, although it is an excellent tool to help you, you should also bear in mind that it uses historical data and that, therefore, what has happened in the past does not always happen in the future. In other words, it is important to know that it can be of great help, but it is also important to be aware of its limitations.
How to perform Effective Backtesting
For backtesting to be useful and provide you with valuable information for your strategy, it is important that you take into account a series of aspects; otherwise, it can provide you with information that is not very valuable and even misleading if certain aspects are not well managed.
Steps for backtesting
- Start by being clear about your trading strategy. Define well what you want to achieve, what are the rules you must take into account and what is the level of risk you are going to assume and how you are going to manage it.
- Access historical data. Keep in mind that you should choose an appropriate time period that includes various market scenarios.
- Choose a reliable backtesting platform. Make sure it has references and that it suits your level of experience, the type of strategy you use and, especially, your analysis needs.
- Execute your strategy with historical data and record the results.
- Analyze the results well. It is worth investing time in it and assessing and calculating key metrics such as profitability, Sharpe ratio and maximum drawdown.
- Adjust your strategy according to the results. Make the necessary adjustments and retest your strategy as many times as you need, modifying parameters, market cycles, different assets, etc.
How much time to devote to backtesting?
The truth is that there is no single answer to this question. It will depend on your strategy and, especially, on the experience you have in trading. What we can recommend is that you take the time to test and don't be in a hurry. Test for a few weeks and gain experience if you don't have it and/or perfect your strategy as much as necessary before implementing it. The more you work and perfect your backtesting, the more confidence you will have when implementing your strategy.
Tips for correct backtesting
- Choose the right data. The choice of data is one of the most important variables. Use high quality historical data and include periods of high volatility and trend changes.
- Don't adjust your strategy to fit historical data. It could lead to over-optimization.
- Record all backtesting results that may be useful for your strategy.
Platforms and tools for Backtesting
Choosing the platform you are going to use for backtesting is probably the most important thing for your strategy to be as successful as possible. We explain some aspects that you should take into account when choosing a backtesting platform.
How to choose the best backtesting software?
When choosing a backtesting software, choose the one that:
- You will find it easy to use.
- Be compatible with the markets and assets you wish to trade.
- Have references on the quality and accuracy of the historical data you use.
- Offer customization and automation of strategies.
- Be compatible with a specific broker or platform if you use them to trade in the market.
- Have a cost that suits what you are willing to invest in backtesting. Note that there are also free options.
Free Backtesting Options
Some popular free platforms for backtesting are:
- TradingView: With a wide range of technical analysis tools, it offers an intuitive interface that makes it an ideal choice for beginners, but also for advanced traders thanks to its wide range of options for customizing strategies and its ability to access multiple markets.
- MT4/MT5: MetaTrader platforms offer a wide variety of indicators and analysis tools for advanced backtesting, as well as the ability to run automated strategies with experts and compatibility with numerous brokers.
- Python: With a versatile and easy-to-learn programming language, it allows you to use libraries for data analysis and trading algorithms, which can be of great help to you in developing and customizing complex backtesting and automated trading strategies efficiently.
Comparison: TradingView vs GoCharting vs FX Replay
Here is a brief comparison between three popular backtesting platforms:
- TradingView: Intuitive interface, large user community, free version with limited features. Its versatility is, in our opinion, the highlight.
- GoCharting: Powerful analysis tools, multi-market support, affordable subscription plans. Its charting-focused approach and the collaboration tools it offers so you can exchange trading analysis is the highlight of this option.
- FX Replay: Specializing in backtesting Forex strategies, high quality historical data, easy to use interface ideal for those who value practicality and being able to make effective simulations in the Forex market.
Backtesting in MetaTrader 5 (MT5)
MetaTrader 5 is a popular platform for Forex and CFD trading. One of its main advantages is the integrated backtesting function. To perform backtesting in MT5:
- Develop your strategy using the MQL5 language or use an expert advisor (EA).
- Open the "Strategy Tester" tool in MT5.
- Configure the backtesting parameters.
- Run the backtesting and analyze the results.
Manual vs. automatic backtesting
You can set up backtesting manually or automatically. Each option has its pros and cons and, therefore, you should choose the one that best suits your preferences.
Advantages and disadvantages of each method
Manual backtesting:
- Advantages:
- You can better control the whole process and even understand what you are proposing in the strategy.
- You don't need programming skills.
- Disadvantages:
- It will take you quite some time to implement it.
- It is easier for you to make mistakes.
- It has more limitations as you will hardly be able to test it in different scenarios.
Automatic backtesting:
- Advantages:
- It is much faster and more efficient.
- It is less prone to human error.
- It will allow you to test your strategy in a larger number of scenarios.
- Disadvantages:
- Requires programming skills.
- It can lead to over-optimization if not used correctly.
How to do manual backtesting?
To perform manual backtesting:
- Define the rules of your trading strategy.
- Use historical charts to manually apply your entry and exit rules.
- Record the details of each transaction, including the entry price, exit price and net result.
- Calculates performance metrics such as profitability, Sharpe ratio and maximum drawdown.
Automatic backtesting with specialized software
To perform automatic backtesting, you will need to use specialized software or program your own solution. In either case, it is important that:
- code your trading strategy using a programming language that is compatible with the backtesting software.
- Configure the backtesting parameters.
- You run the backtesting and analyze the results generated by the software.
- Make the necessary adjustments to your strategy based on the results you have obtained and retest it as many times as you consider necessary.
Interpretation of backtesting results
This is another of the most important points of backtesting because only if you know how to interpret the data well will it really help you. A good interpretation of the data is fundamental for you to make the right decision regarding your strategy.
How many operations are sufficient for a reliable backtest?
We are sorry we cannot give you a concrete figure, but the reality is that there is no number that guarantees the reliability of a backtest. What is clear is that the more you practice and the more trades you make, the more reliable the results can be. Generally speaking, we can say that at a minimum you should make about 30-50 trades to get an idea if your strategy is effective or how effective it is. From there, you may need more tests until you get results that can be meaningful for decision making. In any case, if you really want to have the most reliable analysis possible, testing with at least 100 trades is a good starting point.
Analysis of key metrics in backtesting
When analyzing your backtesting results, consider paying special attention to:
- Profitability: The total performance of your strategy during the backtesting period.
- Sharpe Ratio: A measure of the risk-adjusted return of your strategy.
- Maximum drawdown: The largest percentage loss experienced by your strategy during the backtesting period.
- Percentage of winning trades: The proportion of profitable trades compared to total trades.
- Average profit/loss: The average size of winning and losing trades.
Common mistakes and how to avoid them
Backtesting is no stranger to error. Even when you are experienced in backtesting, you are likely to make mistakes. Here are some of the most common ones so that you can avoid them.
Over-optimization in backtesting
Over-optimization occurs when you over-adjust your strategy to fit historical data. This excessive adjustment can lead to poor performance in actual trading. To avoid over-optimization:
- Use an out-of-sample data set to validate your strategy after initial backtesting.
- Avoid adjusting too many parameters in your strategy.
- Don't rely solely on historical patterns.
The importance of forward testing
Forward testing involves testing your trading strategy in real time after you have completed backtesting. It is a fundamental step to validate the performance of your strategy in current market conditions, so we advise you to spend some time forward testing before investing real capital in your strategy.
Backtesting for different markets
Backtesting techniques can be applied to various markets, but you should know that each of them has its own characteristics. We explain some of them here:
Forex Backtesting
When backtesting in the foreign exchange market, keep in mind:
- Currency pairs can have different volatility and trend characteristics.
- Given the decentralized nature of this market, historical data may be less reliable than for other markets.
- Consider the impact of swaps and transaction costs on your backtesting results.
Backtesting for stocks and options
- Take into account market events that may have an impact, such as dividends, splits and mergers.
- Consider the impact of transaction costs, especially in high-frequency strategies.
- For options, be sure to use historical data that includes information on implied volatility and time to expiration.
Additional resources to improve your backtesting
Backtesting is a somewhat complex field, so in order for you not to get "lost" and take more advantage of the benefits it offers, it is important that you consider some resources that can help you.
Recommended courses and tutorials
- Coursera: "Computational Investing" by Georgia Institute of Technology
- Udemy: "Algorithmic Trading & Backtesting with Python" by Holczer Balazs
- YouTube: "Backtesting Strategies" by Adam Khoo
Trader communities to share strategies
You may also find it useful to share and exchange information with other traders. In this case, you will find useful communities such as:
- MyFXBook: An online community where traders can share and analyze trading strategies.
- Reddit: Subreddits such as r/algotrading and r/ForexStrategies, ideal for discussing and learning about backtesting.
- Trading forums: Popular forums such as Forex Factory and BabyPips have sections dedicated to trading strategies and backtesting that can be of great help to you.