In a trader’s toolbox, backtesting is one of the primary tools that enables them to build an effective trading strategy by using historical data to quantify the risk and returns and decide the move before investment.
And today, most traders depend on this historical data based market movement analysis process to trade in the market. And trading bot backtesting is becoming popular among many traders. So, if you are curious about backtesting, read on. Today, we will discuss what backtesting is and how it can help your trading strategy.
What is Backtesting?
If you are eager to know about backtesting and how it can improve your trading strategy, you must learn exactly what it is. Backtesting is a crucial component of efficient trading strategy development. Backtesting is a method of analysing the potentiality of a trading strategy by implementing it on a couple of real-world historical timeframes. It tests your trading strategies by using historical data to come to a decision.
Backtesting results help you pick one strategy or trading move over others to maximise your investment gain and bring the best outcome. Backtesting solely depends on the concept; strategies that have worked well in the previous market trading, assuming that it will eventually work well in future market trading (as per historical data).
How Does Backtesting Help Your Trading Strategy?
Backtesting has become an essential part of today’s trading strategy development, and many traders rely on this tact to get better outcomes. Also, the backtesting method can be implemented manually or technically, which makes it more accessible for traders to use their trading strategy. And platforms like leading Algo trading software can help you implement backtesting in your trading strategy.
Here are some ways backtesting can help to improve your trading strategy.
-> It Helps to eliminate faulty trading moves.
Backtesting is a process that tests your trading strategies by applying them to several historical timelines to analyse their potential market performance. The primary rule of backtest is to test a trading strategy depending on its past performance to determine its future potentiality. For example, if buying x stock in a particular market environment and time frame did not work well in the past, it will not work well in the same situation in the future.
Also, backtesting uses multiple historical data that helps you understand a strategy’s potential outcome depending on past events. So, when you use backtest, you can easily determine whether a trading move can work for you or not. This way, you can always test your future trading strategy and eliminate any wrong move before implementing it in your trading.
-> Use of large data
Usually, incorporating large data to analyse the trading strategy is an essential yet most challenging task for traders. But when it comes to backtesting, you can quickly and conveniently use large data for analysis. Using such a vast data collection allows you to get more in-depth knowledge about the trading market movement and identify the best trade strategy.
The back test of your trading strategy involves large data, and you can easily diversify your trading strategy. And diversifying your trading strategy can help to reduce the correlation between your strategies. Lowering the correlation among your trading strategies or moves can help you save yourself from money loss. For instance, if there is zero to minimal correlation between your strategies and if you lose money in one trading move, it will not impact other strategies and prevent more financial loss.
-> Enables automation in trading
There are two ways for backtesting. You can test your trading strategies manually or opt for automatic backtest with trading bot backtesting. Both of them offer similar efficiency and productivity in backtesting. The backtesting bot-enabled trading platforms help traders to automate their trading strategy and use the full potential of trading. Also, when you can automate your trading strategies, you can save a lot of time comparing different trade options and quickly move to live trading with your tested strategy with a simple click to a code or check a box to enable automation.
-> Cuts out emotion from trading
Investing in trades and closely observing the trading market creates a sense of attachment to the money you have invested and your strategies. It can lead to becoming biased with some strategies in negative and some in positive ways. And when it occurs, you tend to overrule the system and calculated strategy and opt to buy or sell over intuition, more commonly known as trading biases.
However, your intuition may not lead you to a profitable move, and you can lose your money instead of gaining profit. Mostly, traders tend to sell in panic when the price goes down or buys after a significant price rise. But in reality, you may need to do the exact opposite to gain profit. Unless you backtest, you will never know what will be a profitable move, buying, selling or holding. Backtesting allows you to automate your trading strategy and stay distant from the investment so you do not get attached and trade on bias. Therefore, you can expect better outcomes from your trading strategy when you use backtesting and make a move without being emotionally attached or biased against or for something.
-> Saves your time
Backtesting allows you to generate and test thousands of trading strategies in a short time. The powerful software used in the Algo trading app uses backtesting.
To test the potentiality of thousands of different trading strategies in a single day. So, when you use backtesting. It can effectively reduce the time of comparing and testing each strategy and finding a suitable match. Not only that, it can easily falsify faulty strategies and identify potential trading ideas quickly.
How to backtest your trading strategy
Backtesting relies on historical data which show an asset’s price movements in various past timelines. The process may need historical data of some weeks or some years of a trading strategy. It entirely depends on the nature of the trading strategy one is trying to build, whether short-term or long-term. Following are the steps you can use to manually back–test your trading strategies.
- Decide the parameters for backtesting a strategy.
- Decide the chart timeframe and financial market on which you wish to test the trading strategy.
- Search for trades in the past timeframes. Your choice of timeframes must reflect your purpose for backtesting.
- Find entry and exit points by analysing the price charts. For this, you must locate, mark and write down all trades up to the current time showcased on the chart.
- Record the trades on the chart (both losing and winning) and tally them up to find the gross return.
- Find the net return or a trading profit and loss over a specific timeline. Deducting trading costs and commissions from the gross return is necessary to get the net return.
- Get the whole period’s percentage return by comparing the net return with the needed market capital or exposure. The percentage return indicates the performance of the trading strategy.
Conclusion
Nowadays, trading bot backtesting strategy has become crucial for effective trading strategy building. And it can efficiently improve your trading strategy in more than one way. However, you must avoid some common mistakes like small sample sizes, overlapping and poor-quality data for backtesting. However, you must also remember that trading market dynamics are ever-changing. Like other trading strategies, backtesting cannot offer guaranteed success every time.