What is Backtesting? You must have read a lot about the backtested performance of trading systems on websites. With Backtesting, traders can actually test their trading strategies and how well they would have done if executed in the past. Backtesting any trading strategy allows a trader to simulate its expected performance using historical price data.
Now an important question that comes to anyone’s mind is what type of a trading strategy can be backtested? Any trading strategy that does not have any ambiguity in its rules can be backtested effectively. Example of a simple trading strategy that can be backtested can be as follows.
When the DMI+ is above DMI- and the MACD histogram has crossed above the zero line, go long when the 5 period moving averages has crossed above the 20 period moving averages. When DMI- is above DMI+ and the MACD histogram has crossed below the zero line, sell short when the 5 period moving averages has crossed below the 20 period moving averages.
Are backtested trading systems reliable? Why so much backtested performance is quoted on the websites to prove that the trading system is good? You must know that using the past price data to simulate future results often misleads traders into thinking that their backtested results will also give into similar results in actual real time trading. This one example is just meant to illustrate that any trading strategy having clear cut rules can be backtested with the historical data.
There is much difference between live trading performance and the backtested trading performance. Many potential factors can and will make hypothetical performance and actual performance differ significantly. So you should not fall into the trap of thinking that Backtesting may be a perfect method for identifying the most profitable trading strategies.
Market fundamentals keep on changing. This makes a trading strategy that may have worked very well over the past three years work in an entirely different manner for the next three years as the market changes and evolves. One of the most important facts that you should always keep in your mind is that market changes considerably overtime.
Technical indicators also need to change with the market. Do you know that often technical indicators that have been giving profitable signals in the past are subsequently unable to replicate their performance in the future? This may frustrate you. But this is exactly what makes trading a challenging endeavor.
Secondly, real time trading and trading with the past historical price data are two different things. A trading strategy in real time may be much different from the way the trading strategy behaves on Backtesting in term of trade execution. These differences can potentially skew the results.
However, you should still not underestimate the benefits of Backtesting. Backtesting can provide a trader with a reasonable expectation of the trading strategy’s potential worth and usefulness. Backtesting is still the best available method for evaluating a trading strategy without actually trading it in real time environment.
What are the methods to do Backtesting? Backtesting can be done by using two methods. The first one is the automated Backtesting. The second is manual Backtesting. Automated Backtesting is the most popular method. Automated Backtesting entails using a specialized program. The trader inputs the specific rules and criteria for the trading strategy into the Backtesting program.
Automated Backtesting is very easy. An entire picture of the past performance is created with the help of that software program. The software automatically applies those rules to the past price data and tallies the past hypothetical profits, losses and other information.
The second method of Backtesting is performed manually and visually by the trader. Why would someone do a manual backtest? There are difficulties in doing Backtesting manually but at the same time there are a few advantages of Backtesting. The trader would take the historical data and scroll back in time on a chart and manually apply the trading strategy as if it was in a real time environment.
One of the major drawbacks with manual Backtesting is hindsight. How to eliminate the hindsight factor while doing manual Backtesting? The trader would advance the chart bar by bar in order to refrain from seeing price action subsequent to the trade at hand. This eliminates trading in hindsight that is detrimental to an objective backtest.
The major disadvantage of Backtesting as compared to automated testing is the significant potential for human error in executing simulated trades and recording performance results. Manual Backtesting is complicated and difficult. It requires a lot of patience on part of the trader.
Emotions are your enemy in trading. When you do manual Backtesting, these emotions can cause problems for your Backtesting results. The normal range of human emotions and biases that often interfere with actual trading can be a detrimental factor in achieving objective backtest results. Furthermore, it takes a great deal of work and discipline to simulate trades manually over a large data set without straying from the strict rules of the trading strategy.
These were some real disadvantages of manual Backtesting. However, this provides valuable trading experience although simulated but still a valuable trading experience that no automated backtest could possibly provide. Backtesting manually can provide the trader with the real feel for actually trading the strategy.
No matter whether you do Backtesting manually or automatically, Backtesting can save traders a great deal of time and money that might otherwise had been wasted on trading unprofitable strategies. Backtesting whether done manually or automatically can be one of the most important elements of building a solid trading strategy. Backtesting is now an important element of testing a trading system performance.
You must have heard a lot about the benefits of autotrading. Autotrading is the latest fad especially in forex trading where the number of major currency pairs is only six. This makes programming forex autotrading easy. Any mechanical trading system can be backtested. This leads us to the important question of autotrading. These autotrading systems are popularly known as Expert Advisors or Forex Robots.
In contrast, stock autotrading systems can be big more complicated. The US Stock Market has got more than 50,000 stocks listed with them as compared to the forex market where there are not more than six major currency pairs. This makes programming a stock trading robot a bit complicated. However, during the past decade major breakthrough in computer programming has been made.
An autotrading system needs to be thoroughly tested before being put to live test. The only way to do this is through Backtesting. Backtesting is one of the most important components of testing an autotrading system. Big institutions like banks, corporations and hedge funds have always been taking benefit of these autotrading systems.
So what type of trading strategies can be backtested and autotraded? Any trading strategy that is rule based and is not discretionary or discrete. These types of strategies are primarily technical in nature, and they must necessarily have rules and criteria that are unambiguous. Backtesting and autotrading are two important components of implementing trading strategies that generally do not rely upon the trader’s judgments or discretion.
Backtesting gives you the benefit of testing your trading system on a large historical dataset. Backtesting allows the trader to determine if a given strategy would have been profitable using past price data, which is an indication of how it might potentially perform in the future. In contrast, autotrading actually executes real trades automatically according to a pre – programmed set of instructions that sets trade entries, stop losses, and profit limits.
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