The financial sector is the most dynamic and fast-paced in the world and every decision requires extensive testing and planning. Backtesting is to check the strategy’s performance over historic data. It is especially useful in financial trading such as Forex and stocks. Investors often use backtesting of various types to ensure their long-term strategies generate profits. Let’s test why backtesting is so important in all aspects of the financial sector and how it works to ensure proper planning.
What is backtesting?
Backtesting is primarily used in financial trading and investing where traders and investors check their strategy’s performance on historical data. Traders use it in all assets to ensure their strategies can be viable. Backtesting in FX simply means to analyze strategy over a set period of data and check if it would generate money. For example, a trader who wants to check trading strategy on EUR/USD, might recall data from previous months and see if their strategy is profitable. The process of applying a trading or predictive model to historical market data to evaluate its potential performance is critical in trading. Without backtesting, traders would just aimlessly trade the markets and lose money.
Traders and investors run exact rules of strategy – entry, exit, position sizing – against past price action and record results in a trading journal to analyze results.
How backtesting works
To run a backtest, first you need to collect data by downloading it from reliable sources. Modern trading platforms like MetaTrader 4 and 5 come with built-in addons, enabling for quick download of high-quality data. Traders select the instrument and timeframe to download price data for a specified period. Depending on the trading strategy and financial goals, users might clean the data to remove gaps, outliers, and biases.
After the data has been acquired, traders switch to strategy simulation. This is possible either via manual backtesting or encoding rules in an automated trading system (Expert Advisors). While EAs or Expert Advisors are faster, they require knowledge of coding in specified programming languages. Manual backtesting on the other hand, is much easier and can be done by anyone. Traders just load the charts, select timeframe and asset, and look back at price action to check the validity of their strategies. After writing down the results, it is time to check the performance such as shape ratio, win rate, risk-reward, and so on. This is critical to define a reliable strategy. If the strategy showed promising results, traders can then switch to forward testing, meaning, they open a demo account and trade in live markets using virtual cash.
Why backtesting is critical in financial sector
Backtesting is not done only in trading and investing. Institutions use it for risk management and regulatory compliance. Regulators require banks to validate their VaR (Value-at-Risk) models via backtesting. They compare predicted versus actual losses to ensure the capital is sufficient. Model validation is crucial in trading and traders and quant firms achieve this using backtesting. This way, it is possible to build confidence in automated strategies by verifying that historic performance is robust and not caused by random chances.
Backtesting is also used for developing completely novel approaches to trading, investing, and risk management. In algorithmic and high-frequency trading (HFT), backtesting is the foundation for assessing the strategy’s profitability and stability before deployment in live markets.
Main benefits revealed
There are numerous benefits of using backtesting such as:
- Strategy development – Backtesting is a critical step for trading and investing strategy development, for finding viable methods.
- Strategy optimization – Backtesting can also be used to optimize strategies and fine-tune parameters such as indicator settings and risk management.
- Model flow analysis – Backtesting reveals hidden errors and enables traders to eliminate unrealistic expectations that could lead to poor performance.
- Performance checking – Provides quantitative metrics for comparing multiple strategies and check their performances to select the most promising candidates for further tweaking.
How to properly backtest
One important challenge which needs to be addressed during a backset is overfitting. If a trader selects a specific moment in price history they might develop a profitable strategy for that exact moment, and when deployed in live markets the strategy will lose money. Selecting a considerable amount of data is important to have enough sample size of trades to determine how profitable the strategy would be. Another important step is to include realistic costs such as spreads and trading commissions which are often overlooked in backtesting and can lead to a losing system. Another error is to rely upon backtesting and not perform a forward testing. In forward testing, traders use the strategy on a demo account to see how reliable it is in live market scenarios.