Mastering Trading Strategy Backtesting: A Beginner’s Comprehensive Guide

As a new trader, creating an effective trading strategy is a must. However, you need to put a lot of effort before you can successfully achieve a reliable strategy. Fortunately, there’s a process called backtesting. It’s when you can simulate your trading strategy, and see whether it’s ready for the actual market, and you can make a profit.

In addition, knowing how to do backtesting is an essential skill that can help you improve your trading performance. In this article, we’ll guide you in understanding backtesting and preparing the things you need before you get started.

What is Backtesting?

Backtesting is checking the effectiveness of a trading strategy by applying it to past market data. Traders conduct this method to test whether their trading strategy can perform when in various market conditions. When doing so, they can also identify the specific weaknesses, patterns, and potential profitability level of their trading strategy.

Why Backtest Your Trading Strategy?

1. Validate Hypotheses

When crafting a trading strategy, traders usually assume its reliability. Of course, they gather information and analyse them to make an informed decision. However, they can’t guarantee the effectiveness of the trading strategy unless they test it. Fortunately, with backtesting, you can validate your hypotheses by trying them on historical data.

2. Identify Weaknesses

Even if you think you’ve created the best trading strategy, it doesn’t guarantee success. Besides, as you’re aware, the market undergoes various changes, such as volatility, low liquidity periods, and crashes. However, if you backtest your trading strategy, you can find its weaknesses, and improve its quality.

3. Enhance Confidence

Once you perform backtesting, and you notice that your strategy is doing well, it can enhance your confidence to start your trading journey. At the same time, it can help reduce the risk of being emotional, especially since you’re just starting to figure out how to become an official trader.

4. Optimise Parameters

If you’re still not used to adjusting parameters, such as profit targets, stop-loss orders, and time frames, you can practise them through backtesting. Of course, you can also do so using your demo account, but with backtesting, you can identify results using various market conditions. Meanwhile, with a demo account, the results are just based on the current market conditions.

Steps to Backtest Your Trading Strategy

1. Define Your Trading Strategy

Before you conduct backtesting, you should finalise your trading strategy first. It should be clear, logical, and based on various criteria, including stop-loss, entry and exit signals, and profit-taking conditions. In addition, there shouldn’t be room for subjectivity, and solely base your strategy on data and facts. This allows you to come up with a strategy that can work on various market conditions.

2. Choose the Right Backtesting Platform

Choosing the right platform is another essential thing you should decide on when conducting backtesting. Some of the most popular platforms include TradingView and MetaTrader. But no matter which trading platform you choose, ensure that they can provide the tools that you need to get accurate results.

3. Gather Historical Data

Another thing that should be reliable is the historical data. It should match the market you’re planning to trade, and the timeframe. You can find a lot of free data sources online, such as Yahoo Finance, and Quandl. However, if you have a budget, you may also opt to get more detailed data from paid sources.

4. Simulate the Trades

Once you already have accurate data and a reliable strategy, the next step is to run the backtest. In doing so, you’re going to apply your strategy in a series of trades. If you constantly generate successful trades, this means that your strategy works well with the market conditions. On the other hand, if various trades fail, you should make the necessary adjustments to your strategy.

5. Analyse Performance Metrics

After the simulation, record and analyse the performance of the strategy. Know the number of wins and losses, risk-reward ratio, max drawdown, and other relevant metrics.

6. Optimise and Adjust

After analysing the performance of your strategy. The next step is to optimise and adjust accordingly. However, be careful when it comes to optimising based on past data since overdoing it may result in losses for trades based on the current market conditions.

7. Conduct Forward Testing

After making the necessary adjustments to your strategy, you can now run it on your demo account, also called forward testing. It’s when you run your trading strategy on the current market conditions. This allows you to know if your strategy still works in the real-time market, without risking your capital.

Final Thoughts

As a trader, it’s crucial to know how to backtest, especially as a beginner. While it doesn’t guarantee consistent wins due to various factors that may affect the market conditions, you can still identify whether it works.

Let us know your thoughts about utilising the benefits of backtesting on your trading journey by commenting below!

ABOUT THE AUTHOR

Aliana Baraquio has over 5 years of experience as a writer and market analyst. She specialises in developing beginner-friendly trading techniques and tutorials. Additionally, she suggests FP Markets as the top broker for trading CFDs and Forex.