It is an essential trading tool, an indispensable part of any trader’s toolbox. Think about what you do before you purchase a car or even a television set. Don’t you thoroughly check the brand, its history, its past products, services? All these provide an idea if the money you are spending is worth it. Now, in the case of trading, the same kind of principle is applied.
So, what is backtesting? It is a trading approach. It is the way to test a trading strategy or hypothesis on specific time periods. It is also used by a number of expert advisors and forex robots to test their strategies before their products are available on the market. It is the way the viability of any trading strategy is assessed and the way to find how it works, with the help of historical data. This is where the differences come up, and many believe that the technique is useless. But several traders and analysts believe that if back-testing works, analysts, and traders gain immense confidence, and they happily use it in the future.
Understanding the purpose of backtesting
Traders use the process to test and then compare different trading techniques. The best part is that there is no money involved in the process, and there is no worry about risking or losing money. It works on the concept that if any strategy did not fare well in the past, it will definitely not do well in the future either. In any such event, the two components which are basically looked at are the risks involved and the total profitability.
Such testing usually analyses the performance based on various factors. A trader gets to know about strategies that have shown great results in the past. However, it should not be forgotten that a market does not remain the same forever, and conditions do not repeat. Thus, backtesting is mainly based on the assumption that stocks move in the same patterns as they did in the past.
Why does backtesting not work at times?
Most traders only back-test their trading strategy to be sure that it will provide accurate information about the expectations. However, what happens when you are left clueless after the failure of your trading strategy, even though it showed remarkable results in back-tests? There are quite a number of mistakes you can commit while back-testing, explains some of the short-falls of this process. Here are some of the commonly occurring mistakes, which are likely the reason why back-testing isn’t working for you.
Treating it like a game
In a normal back-testing software, buying and selling can be done with one mouse click, moving forward in time is very easy, and you can pause any time if you wish to take a break. However, it may so happen that you push the wrong button, moving a candle too far. The main danger here is to ruin your trading style while making back-tests. Since back-testing does not have any negative effects on a trading account, traders tend to approach it in a sloppy manner. Such careless back-testing ultimately affects live trading.
Not being able to judge the news
News pieces from around the world have a definite effect on markets. This includes politics, companies publishing financial statements, or other unexpected or anticipated geopolitical events. Major price movements are caused by some of these news events, which can also be the cause behind unexpected spread developments or signaling the beginning of a trend. However, when you are back-testing, you are enabled to instantly see why prices in a particular past data had spiked up. The absence of this knowledge can lead you to overestimate the results of your back-tests. Eventually, after applying the strategy in a live environment, you can easily get results that you weren’t expecting, with the chance of ending up with huge losses.
Relying too much on historical data
A common advertising ploy for most expert advisors and forex robots is that they’ve tested their system on 30 to 40 years’ worth of historical data. While historical data is important, relying on them too much is mere time-wasting. Markets are almost like living organisms that evolve and change in the aspects of volatility, price, support, and resistance. Simply testing 1 to 2 years of historical data and replay price in real-time should be enough for you to judge whether the system has a promising outlook and is ready to be tested in live markets.
Taking mid-candle decisions
The success of a trader depends greatly on how he or she avoids premature or knee jerk reactions in the market. Back-testing can eliminate impulsive trading decisions. When you are using a candle by candle back-testing method, it may get very boring. But if you want to make your back-tests as accurate as possible, use real-time market speed. You should speed up the movement of the price as little as possible. The process might seem boring and dull, but it’s the only way you can train for a real-market environment.
For successful backtesting, there are a few things that you need to follow. When you try backtesting, do not go with data that is too old. It is wise to backtest just 1-2 years. Never rely on anyone’s particular software for conducting your back-testing, and try to get a simulation software that will let you monitor different markets, timeframes, and instruments. Also, keep in mind that a lot must have taken place over this time, which could have affected the market.
You need to consider these facts as well when considering backtesting. Remember, back-testing isn’t a guarantee on how your trading strategy will perform in the future. Just accept the fact that nothing can beat your trading experience when you use your own money.