Is backtesting a trading strategy worth the time and effort? Given that most professional fund managers backtest their methodology then the answer is a resounding yes.
Backtesting may have limitations and it may not provide all the answers but it does provide valable learning and insight.
Be aware that backtesting is not live trading, so the circumstances and emotions are going to be different when real money is not being made or lost. However, it can help validate a trading approach and give you confidence to ‘go live’ based on what you have learned.
If your strategy has proved its worth in theory, then you’ll be more assured to act in practice when the next trade signal shows up.
Technology plays an important role too - backtesting software allows you to learn quickly. For instance, you can analyse six months or a year’s worth of Forex price statistics in just minutes.
You set the agenda based on your distinct trading approach – the backtesting software then tests the reliability of this strategy. The backtesting software accurately manipulates the price data and applies your trading rules to it.
Your trading strategy rules need to be specific and consistent, so to understand when to take a trade when pinpointed on a chart. Without specific rules that you can follow every single time you trade, it will be impossible to backtest your strategy.
What you need to back test
You will need price data or a charting package as well as backtesting software. There are no shortage of providers offering backtesting software but shop around as they often have different features/strengths.
Sometimes data available to backtest can be fairly limited (for instance one to three months on a five-minute chart).
In essence, backtesting involves moving one candlestick (time-period) at a time until you see a trade setup you would take under your trading strategy. Future price movements should always be hidden so you don’t see the result of your trade until after you have agreed to take it.
There are several problems you might encounter when you backtest your trading system, so you need to be aware of them. We’ll pick out a few and suggest possible remedies.
Postdictive error means you have used data only available after the fact to test your system. It is a common error when backtesting.
For example, a feature of your system may be the closing price. If so, the trade cannot be initiated until the day is over, otherwise this is a postdictive error. The way to avoid the postdictive error is to ensure that when you backtest, only information that is available in the past at that point in time is used.