What Is Backtesting?

Backtesting is the general method for seeing how well a strategy or model would have done after the fact. It assesses the viability of a trading strategy by discovering how it would play out using historical data. If backtesting works, traders and an🅘alysts may have the conf⛎idence to employ it going forward.

Understanding Backtesting

Backtesting allows a trader to simulate a trading strategy using 澳洲幸运5官方开奖结果体彩网:historical data to generate resul൲ts and analy🍨ze risk and profitability before risking any actual capital.

A well-conducted backtest that yields positive results assures traders that the strategy is fundamentally sound and is likely to yield profits when implemented in reality. In contrast, a well-conducted bac✨ktest that yields suboptimal results will prompt traders to alter or reject the strategy.

As long as a trading idea can be quantified, it can be backtested. Some traders and investors may seek the expertise of a qualified programmer to develop the idea into a testable form. Typically, this involves a programmer coding the idea into the proprietary language hosted by the trading platform.

The programmer can incorporate user-defined input variables that allow the trader to "tweak" the system. An example of this would be in the 澳洲幸运5官方开奖结果体彩网:simple moving average (SMA) crossover system. The trader would be able to input (or change) the lengths ౠof th♔e two moving averages used in the system. The trader could then backtest to determine which lengths of moving averages would have performed the best on the historical data.

The Ideal Backtesting Scenario

The ideal backtest choꦫoses sample data from a relevant time period of a duration that reflects a variety of market conditions. In this w💎ay, one can better judge whether the results of the backtest represent a fluke or sound trading.

The historical data set must include a truly 澳洲幸运5官方开奖结果体彩网:representative sample of stocks, including those of companies that eventually went bankrupt or were sold or l♏iquidated. The alternative, including only data from historical stocks that are still arou♍nd today, will produce artificially high returns in backtesting.

A backtest should consider all trading costs, however insignificant, as these can add up over the course of the backtesting period and drastically affect the appearance of a strategy’s profitability. Traders should ensure that their 澳洲幸运5官方开奖结果体彩网:backtesting software accounts for these costs.

Out-of-sample testing and forward performance testing provide further confirmation regarding a system's effectiveness and can show a system's true colors before real cash is on the line. A strong 澳洲幸运5官方开奖结果体彩网:correlation between♓ backtesting, out-of-sample, and forward performance testing results is vital for determining the viability of a trading system. 

Backtesting vs. Forward Performance Testing

Forward performance testing, also known as 澳洲幸运5官方开奖结果体彩网:paper trading, provides traders with another set of out-of-sample data on which to evaluate a system. Forward performance testing is a simulation of actual trading and involves following the system's logic inꦆ a live market. It is also called ཧpaper trading since all trades are executed on paper only; that is, trade entries and exits are documented along with any profit or loss for the system, but no real trades are executed.

An important aspect of 澳洲幸运5官方开奖结果体彩网:forward performance testing is to follow the system's logic exactly; otherwise, it becomes difficult, if not impossible, to accurately evaluate this step of the process. Traders should be honest about any trade entries and exits and avoid behavior such as 澳洲幸运5官方开奖结果体彩网:cherry-picking trades or not including a trade on paper rationalizing that "I would have never take♓n that trade." If the trade would have occurred following the system's logic, it should be documented and evaluated.

Backtesting vs. Scenario Analysis

While backtesting uses actual historical data to test for fit or success, 澳洲幸运5官方开奖结果体彩网:scenario analysis makes use of hypothetical data that simulates various possible outcomes. For instance, scenario analysis will simulate specific changes in the values of the portfolio's securities or key factors that take place, such as a change in the 澳洲幸运5官方开奖结果体彩网:interest rate.

Scenario analysis is commonly used to estimate changes to a 澳洲幸运5官方开奖结果体彩网:portfolio's value in response to an unfavorable e𒁏vent and may be used to examine a 🧸theoretical worst-case scenario.

Some Pitfalls of Backtesting

For backtesting to provide meaningful results, traders mu♊st develop their strategies and test them in good faith, avoiding bias as much as possible. That means the strategy should be developed without ♒relying on the data used in backtesting.

That’s harder than it seems. Traders generally bui💎ld strategies based on historical data. They must be strict about testing with different data sets from those they train their models on. Otherwise, the backtest wi♛ll produce glowing results that mean nothing.

Similarly, traders must avoid data dredging, in which they test a wide range of hypothetical strategies against the same set of data, which will also produce successes that fail in 澳洲幸运5官方开奖结果体彩网:real-time markets because there are many invalid 🅘strategies that would beat the ma𓆏rket over a specific time period by chance.

One way to compensate for t༒he tendency to data dredge or cherry-pick is to use a strategy that succeeds in the relevant, or in-sample, time period and backtest it with data from a different, or out-of-sample, time period. If in-sample and out-of-sample backtests yield similar results, then they are more likely to be proved valid.