Backtesting – Key Elements, Benefits, and 10 Golden Rules

We will explain the important things to remember while backtesting your strategy. You are gonna learn about the key elements of backtesting, and important rules to keep in mind. Before we move ahead let us understand backtesting in a simple way.

DEFINITION – 

Backtesting is an essential tool we use for testing our strategy offline before we actually use that strategy in real-time trading. Using the historical data we check the performance of any stock in the past using that particular strategy.

Must Read:- What is backtesting in trading? Why it is important?

KEY ELEMENTS TO REMEMBER

1. DATA SELECTION –

It’s important to select the correct data for backtesting. You have to make sure that the data you have selected has appropriate, useful information and it covers a long enough time frame that offer the insightful information you require.

2. CLARITY OF THE STRATEGY – 

It would help if you made sure that the trading strategy you are going to backtest is well-defined. It covers position sizing, risk management guidelines, and entry and exit requirements.

3. HISTORICAL INFORMATION – 

Consider historical data as your time machine for trading. Your strategies will perform differently under actual market conditions if you have seen the past performance of the strategy using historical data.

4. FORMULATION OF A STRATEGY – 

This is where you can use your thinking to create trading plans that are unique for you and your goals, risk tolerance, and market predictions.

5. EXECUTION –

Make sure to use a tool or platform for backtesting to recreate the strategy accurately.  You need to make sure that the model accurately represents the real environment and pay close attention to the details.

6. PERFORMANCE ANALYSIS OF YOUR STRATEGY – 

         After following all the necessary guidelines mentioned above now here is your result formulation you can see and determine how well your strategies worked. Were the strategy accurate or did they miss the target? You will learn about this here.

BENEFITS OF BACKTESTING –

There are various benefits, here are some of them.

1)HELPS US MANAGE OUR RISK – 

It helps us manage our risk by using a certain strategy offline. We get an idea of how risky a particular strategy is. Before starting trading in real-time we get the risk information so that we can be alert or decide whether to use that strategy or not.   

2)HELP US IMPROVE OUR STRATEGY –

 Through backtesting, we can fine-tune our trading rules and make the necessary modifications to improve our strategies. it assists us in identifying the most advantageous obstacles, entry and exit points, and methods for reducing risks while trading in a particular stock.

3)HELP US TAKING DECISIONS CONFIDENTLY –

It gives us confidence in our decision-making when we are trading in real time. We can execute trades with conviction and trust our rules by examining the past success of our methods and strategies.

4)HELP US BE BETTER AND IMPROVE –

It is a valuable tool for learning. we can better recognize market trends, we can polish our trading techniques, and develop our trading skills by studying the previous trades we did offline.

GOLDEN RULES OF BACKTESTING –

Here are 10 golden rules you can always keep in mind:-

1)UNDERSTANDING THE MARKET TREND –

When you are backtesting a specific strategy you must always take into consideration what was the general market trend at that time

If a technique was only backtested from 2000 to 2002, it might not perform well in a bad market. It’s usually a good idea to backtest over a long period of time that includes a range of various market circumstances.

2)UNDERSTANDING THE MARKET CONDITION –

You should always think about the conditions associated with the backtesting process. For example, testing a large market system on an entire universe of technology businesses might not apply to success in other industries or sectors. It can work unless a strategy applies only to a certain genre of stock, it is often recommended to maintain a broad universe for testing purposes.

3)UNDERSTANDING THE ENTRY AND EXIT POINTS – 

When you are planning a trading strategy, it is necessary to consider indicators to check the volatility of the market. you should make trades to minimize volatility, reduce risk, and make it easier to enter and exit into a particular stock.

4)KEEPING AN EYE ON THE BARS ON THE CHART PATTERN – 

When you are creating a trading strategy it is absolutely critical to monitor the average amount of bars you hold. You should not ignore the fact that commission charges or brokerages are usually included in the final calculations, even if most backtesting software achieves this. If at all possible, you can always reduce commission costs and increase your overall return by holding an average of more bars.

5)LEARNING ABOUT THE EXPOSURE – 

Greater profits or losses might result from greater exposure, and smaller gains or losses may come from decreased exposure. In general, you should maintain exposure below 70% to minimize risk and make it easy to enter and exit for a specific asset.

6)USING THE AVERAGE GAIN/LOSS NUMBER –  

When using strategies to determine the optimal position sizing and money management, it can be useful to combine the average gain or loss figure with the profits-to-loss ratio. Traders may experience decreased commissions and take on larger positions by enhancing their average gains and profits-to-losses ratio.

7)UNDERSTANDING ANNUALISED RETURN TRICK – 

The annual return is an excellent indicator for comparing the returns of an investment system against those of other venues. It is important to consider not just the yearly return overall, but also the increased or decreased risk. This can be achieved by making good use of the risk-adjusted return, which considers several risk qualities. Before adopting, a backtesting trading strategy you need to perform better than all alternative investment venues at the same or lower risk.

8)BACKTESTING CUSTOMISTION – 

Customization is very essential. Your strategy can be adjusted with commission amounts, round (or fractional) lot sizes, tick sizes, margin requirements, interest rates, default assumptions, position-sizing rules, same-bar exit rules, (trailing) stop settings, and many other factors.

9)AVOIDING OVER-OPTIMIZATION – 

Backtesting can result in over-optimization, it is an issue that can arise for you. In this case, performance results are so optimized to the past that they become inaccurate going forward. If the rules are not overly optimized to the point where the person who wrote them is unable to fully understand them, it is usually a good idea to implement rules that apply to all stocks or a specific group of targeted stocks.

10)BACKTESTING IS NOT ALWAYS EFFECTIVE – 

The most accurate technique to evaluate the success of a trading strategy is not necessarily through backtesting. Strategies that were effective in the past may not be effective now. It is impossible to predict future events based only on past performance. Make sure to paper trade a method that has undergone successful backtesting before going live to figure out whether the technique is still useful.

CONCLUSION –

That’s a brief overview of backtesting. It’s a mindset, a method of approaching the stock market with conviction, clarity, and confidence. It’s not simply just any other tool, it is the important and needful one. Remember this the next time when you are feeling alone and confused while choosing your trading strategy, you can never be alone now backtesting is on your side.

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