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Feb 23

How to Backtest Your Trading Strategy With Ease

Reading Time: 4 mins

To ensure that you will be a successful trader, you need to familiarize yourself with backtesting strategies and why those are important.

By doing so, you will be more confident in your trading strategy regardless of whether you are leveraging a mechanical trading system or using a manual trading approach. This article delves into the nitty-gritty of how you can backtest your trading strategy with ease.

 

Importance of Backtesting your Trading Strategy

As soon as you have established a trading strategy that you are comfortable with, you need to ensure that you backtest it to find out if you have valid trading ideas.

The traders behind Trusted Broker Reviews suggest you perform backtesting because it can help alleviate you from weeks or even months of trading failure, depending on your trading time frame. By backtesting, you’ll likely improve your trading strategy.

 

Kind of Backtesting

●      Automated Backtesting

If you have a background in programming or you are well-versed in coding, then this backtesting method could be suitable for you. With this method, you can be sure the backtest results are unaltered. Because everything is automated, this is also considered a more efficient backtest method.

 

●      Manual Backtesting

For most traders, particularly beginners, manual backtesting is more viable. In this method, you need to manually go through the charts and from there, find trades that fit into the trading rules you have set. While this can be quite time-consuming and cumbersome, your efforts will be worth it in the end.

 

What you need for Backtesting

 

●      Charting Package

One of the primary things you need to conduct the backtesting process is a charting package. Fortunately, there are various packages for you to choose from. However, you need to ensure that you go for one that has hundreds of indicators and charts that you can use for stocks, foreign exchange, or commodities. It’s also a good idea to choose a charting package with a huge social community that allows you to exchange ideas with other traders. Some of these charting packages even come with detailed technical analysis and scanning as well as market visualizations. The best part is that most of these packages are free.

 

●      Backtesting Software

Another thing you need to use to perform backtesting efficiently is software dedicated to the process. This program or application should be able to accurately manipulate the price data as necessary. From there, you should be able to apply your trading ideas to it. Just keep in mind that the customization of your backtesting process is extremely important because, otherwise, it can lead to over-optimization, which is a condition where your performance results are tuned so high in the past that they are no longer viable in the future.

 

●      Open Mind

Apart from the tools that you can use, you also need to have an open mind to have a good insight on which trading ideas to backtest. One of the most common trading ideas that you can try to backtest is the double top or double bottom trading strategy. There are other types of trading strategies that you can test but as soon as you figure out the one you intend to evaluate, the next thing is for you to highlight some of the key components involved in that strategy.

 

Rules for Backtesting

 

●      Broad Market Trends

Regardless of the trading strategy that you are backtesting, you need to take into account the broad market trends. Apart from this, you also need to consider a specific time frame to test. For instance, if you have backtested a strategy during the 1999 to 2000 time frame, then your trading strategy may not be viable. Make sure to test the same strategy over a long period that encompasses various types of market conditions.

 

●      Volatility Measures

Another rule in backtesting is to consider the volatility measures possible, particularly for leveraged accounts. The reason behind this is that these leveraged accounts are subjected to margin calls, especially when their equity surpasses below a certain point. What you should be after is to keep volatility low to reduce any risk, which will pave the way for an effortless transition of position for a certain stock.

 

●      Average Number of Bars

When it comes to backtesting your trading strategy, you also need to take into account the average number of bars held. Nevertheless, most of the backtesting software already includes commission costs in the final computations. However, this doesn’t mean that you can take the average number of bars held for granted. As much as possible, you need to raise this factor to decrease commission costs, thereby enhancing your overall revenue.

 

●      Average Gain or Average Loss

The average gain or average loss statistic, when integrated with the wins-to-losses ratio, is a useful factor that can aid you in identifying optimal position sizing. With both of these factors used together, you will be able to take a larger position and reduce commission costs effectively. To further help the latter, you need to increase your average gain and wins-to-losses ratio.

 

●      Annualized Return

A tool to benchmark the returns of a system against other investment venues is annualized return. Apart from taking this tool into account, you could also look into the increased or decreased risk by focusing on the risk-adjusted return. The latter accounts for different risk factors. A general rule of thumb is that before you adopt any kind of trading system, the strategy it involves must be able to outperform different investment venues that you have tested at less or equal risk.

 

Make sure to backtest your trading strategy, not only to gain confidence in your technique but to help prevent excessive losses that can be quite difficult to earn back. Just familiarize yourself with the rules of backtesting to ensure you are doing the right thing. Rest assured that with an effective trading strategy, you’ll increase your chances of being able to earn decent revenue from your trading investment and hopefully be a successful trader in the future.

 

*This should not be taken as financial/investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.

 

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