When developing a trading strategy, you often hear the term, backtesting. Backtesting means checking the strategy on historical price data and evaluating if the strategy would perform profitably. However, this is just a part of developing a trading strategy and not a sole solution to finding a holy grail trading method that generates guaranteed profits. Let’s discuss what is backtesting, why it is so crucial, and how to employ it correctly in your financial trading strategy to get maximum results.
What is Backtesting?
Backtesting is applying a trading strategy to historical market data to test its performance. Since it simulates how the strategy would perform on historic price data, it can provide essential insights into the effectiveness of trading strategies. Some trading platforms even come with built-in plugins allowing backtesting. One such platform is MetaTrader 4 (MT4). Backtesting your strategy on MT4 requires certain knowledge and mastering of the platform and its backtesting feature which is a powerful tool used for Expert Advisors (EAs). For beginners, it is essential to use manual backtesting rather than MT4’s automated one.
How backtesting works
Here is how the manual backtesting process works:
- Determine the rules of your trading strategy
- Determine the asset and timeframe you want to trade
- Go back to 1 month, or 1 year, depending on your preferred data size
- Try to detect trading setups (entry and exit rules) analyze potential returns and stop loss levels
- Write down each trading setup’s final result to determine if it’s a win or loss
When you have at least 30 or 50 trades, try to analyze your strategy’s win rate, average win, average loss, risk-reward ratio, and other important stats.
Why traders must use backtesting
Backtesting is an integral part of strategy development. It is a must-do process to develop a viable strategy and move to the next step of forward testing. Before backtesting we need to have an overall outline of a trading strategy and a list of its rules to know the entry and exit points in the asset.
Backtesting is an important block in the chain of strategy development process and without it, it is impossible to create a viable trading strategy in a reasonable time. Directly heading to forward testing (trading on a demo account using your strategy) will be useless as it will take some time to collect enough sample size for analysis.
The role of quality data in backtesting
Now, not all brokers provide historical data to test all kinds of strategies and traders should ensure that:
- The data is high quality
- There is enough data to collect enough sample size
Reliable historical data is critical to accurately evaluate the strategy’s performance on historical data and get reliable insights about your strategy’s pros and cons. There are ways to ensure your data is correct and reliable. One is to opt for reliable brokers that provide substantial amounts of historical data on their platform’s charts. If you are testing algorithms on backtesting then you might want to download quality data on your MT4 or from trusted third-party sources.
Developing a trading strategy using backtest
Before we backtest our trading strategy, we must complete all preliminary steps. Firstly, outline the idea of the trading strategy and try to translate everything into objective rules to make a list of reasons for entry and exit. This is critical as it is impossible to test strategy on historical price data if you do not have exact reasons to open the trading positions, then manage it, and lastly close it via stop loss or any other manual method. After the first step, traders can proceed to open charts, and go back to have enough candles (bars) to test the strategy. It is essential to have at least 30 trades collected using a backtest to have enough sample size to define whether your strategy works.
What comes after backtesting is forwardtesting
After conducting the backtest, if your strategy seems profitable then it is a good idea to switch to the final step of trading strategy development: forward testing. Forward testing means using your strategy and trading on a demo account. This is to test the strategy in live market scenarios and determine if the strategy is really profitable. Unfortunately, even demo trading is not capable of simulating live trading experience with 100% accuracy, as spreads and commissions often are not charged on most demo accounts and these are important trading costs that can render winning strategies losers. However, if your strategy performs profitably on a demo account it is most likely going to work on a live account as well. It is critical to start small and test strategy in live market scenarios before investing big.
