What is backtesting, and why is it important for online traders

What is backtesting, and why is it important for online traders?

Backtesting plays an important role in trading strategy development. Backtesting is a process in which a trading strategy is tested against historical market price data to assess its performance and potential profitability. Backtesting can be done manually or automatically using trading robots. For instance, you can check the backtesting software reviewed here

Backtesting strategies manually

Backtesting strategies manually

This process involves manually reviewing historical market data and applying the trading rules in a simulated market environment. Manual backtesting takes more time than automatic, on the other hand, traders get a better understanding of how markets move. 

When testing strategies, it’s important to avoid too old data. Trading conditions often change, and it’s best to test your strategies against as recent information as possible. 

It takes a couple of steps to manually backtest trading strategies: 

  • First, define your trading strategy, clearly outline the rules and criteria of your trading strategy. This includes entry, exit and ST (stop loss), TP (take profit) levels. 
  • Gather historical data: collect information on the trading instrument that you plan to test your strategy against. Keep in mind that every asset class, and trading instrument moves differently, and it’s best to create unique trading strategies for certain instruments. 
  • Set the parameters: you need to determine parameters such as timeframe, period, frequency of trades, and trading sessions. You need to take into account liquidity. For instance, you are backtesting day trading strategies on Euro vs USD, you need to define trading hours. It’s no secret that day traders avoid placing orders during low liquidity hours (Tokyo and Sydney trading sessions). 
  • Apply your strategies manually. Keep a record of all trades executed during the backtesting, including entries, exits, and outcome (profit or loss). Later, you will be able to analyze the information.  

What’s great about backtesting is that it enables you to spot shortcomings of your trading system in a risk-free environment. In addition, when your trading strategy is well-tested, you become a more confident trader and fear of placing an order goes away. Furthermore, no matter how great your trading strategy is, every strategy experiences periods of drawdown. When draw-downs happen, traders that are unsure about their systems, dump their strategies and start looking for another one. 

Backtesting strategies help traders gain valuable insight into potential profitability and risks involved in trading. However, it should be mentioned that it cannot guarantee future success. But, backtesting helps traders better prepare and increase their chances. 

Backtesting strategies automatically

Backtesting strategies automatically

Automatic backtesting involves using trading algorithms and robots through trading platforms. Automatic backtesting is very similar to manual backtesting, however, there are various major differences between the two:

  • Automatic backtesting is much quicker, on the downside, it requires more rules and precise instructions for the robots to conduct backtesting.
  • Traders do not get to experience how markets move and gain valuable insight when all the backtesting is done by algorithms, which can lead to poor judgment later. 
  • Because automatic backtesting is quicker, traders can easily back-test different strategies on multiple markets and find the most suitable instruments for the strategy to trade live. 

Automatic backtesting requires a suitable trading platform. For instance, backtesting on MetaTrader 4 (MT4) is possible through utilizing a built-in feature. MT4 is the most popular Forex trading platform. Traders can open the “Strategy Tester” window and select suitable Expert Advisors (EAs). The next step is configuring testing parameters, setting model and tick data, and starting backtesting. Lastly, traders need to monitor and analyze the results. Based on the backtesting results, traders can refine and optimize their trading strategies. They can modify entry and exit rules accordingly and get a better result next time. 

Why is backtesting so important

Trading conditions often change, and backtesting is one of the best tools for traders to develop suitable strategies. In addition to backtesting, traders are actively using demo trading for developing strategies. Backtesting helps traders to increase their confidence, optimize strategies, prepare for trading psychologically, compare different strategies, and improve their trading skills. 

The main takeaways

Overall, we can safely say that backtesting is an important tool for developing and upgrading strategies in a risk-free environment. Traders use manual and automated backtesting tools. And both methods have their benefits and drawbacks. To automatically backtest strategies, you will need a suitable trading platform and backtesting robots. For manual testing, all you need is market data. Keep in mind that the recent data is more valued in backtesting due to the changing nature of market conditions.

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