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The Importance of Backtesting Trading Strategies



What is Backtesting a Trading Strategy?

Backtesting is contemplated to be a crucial tool in a Financial trader’s toolbox, without which they wouldn’t even think of trading into the stock markets. Think about it, before you purchase anything, be it a mobile phone or a house, you would need to review the history of the company, its characteristics, etc., and check if it is worth your investment. A similar principle applies to share trading.

Backtesting is the main element of beneficial trading system development. It is accomplished by reconstructing, with historical data, trades that would have occurred in the past utilizing regulations specified by a given tested strategy. The result gives statistics to assess the efficacy of the strategy.

The underlying theory is that any technique that served well in the past is plausible to work well in the future, and contrarily, any technique that performed badly in the past is plausibly to perform badly in the future. This blog takes a glance at what applications are utilized in backtesting, what sort of data is attained and how to put it to usage.

Backtesting is the main element of significant trading system development. It is achieved by reconstructing, with historical data, trades that would have happened in the past utilizing rules specified by a given strategy. The result gives statistics to assess the efficacy of the strategy.

The elementary theory is that any strategy that operated well in the past is likely to function well in the future, and contrarily, any strategy that performed badly in the past is likely to execute badly in the future. This blog will also provide us various aspects to keep in mind while executing backtesting strategies in stock markets. So, let's dive deep into this blog to further understand the basis of the Backtesting strategy and its effectiveness.

How to Backtest a Trading Strategy utilizing Data and Tools:

Backtesting can give plenty of beneficial statistical feedback about a provided system. Some universal backtesting statistics comprises of :

  • Net profit or loss: Net percentage earned or lost
  • Volatility measures: Maximum perception of upside and downside trends in share markets.
  •  Averages: Percentage average gain and average loss, average trading bars held
  • Exposure: Percentage of wealth invested (or exposed to the stock market)
  • Ratios: Wins-to-losses stocks ratios
  • Annualized return: Percentage return over a year from trading.
  • Risk-adjusted return: Percentage return as a function of risk involved in the stock market.

10 Essential Rules For Backtesting Trading Strategies

There are many facets to pay scrutiny towards when traders are backtesting trading strategies. Here is a list of the most valuable facets to keep in mind while backtesting:

1. Take into account the wide market trends in the time duration a specific strategy was tested. For instance, if a strategy was just backtested from 1999 to 2000, it may not progress well in a bear market. It is frequently a nice idea to backtest over a long time duration comprising of various unique categories of market situations.

2. Take into account the market scenario in which backtesting occurred. For instance, if a broad market system is tested with a sector consisting of tech stocks, it may flunk to do well in various sectors. As a comprehensive rule, if a strategy is targeted toward a particular category of stock, restrict that specific strategy for different sectors, in all different cases, maintain a broader market strategy for all testing purposes.

3. Volatility measures are incredibly significant to contemplate in developing a trading system. This is particularly genuine for leveraged accounts, which are subjected to margin calls if their equity drops below a specific point. Traders should attempt to keep volatility low to lessens risk and facilitates susceptible transitions in and out of a given stock in the share market.

4. The average volume of bars held is furthermore very significant to watch when creating a trading system. Although most backtesting software comprises commission expenses in the final calculations, that does not imply you should avoid this statistic. If possible, raising your average number of bars held can lessen commission expenses and enhance your all-around return.

5. Exposure is a double-edged technique. The high exposure can direct to higher revenues or higher losses, while decreased exposure implies poorer profits or lower losses. In common, it is a nice idea to maintain exposure below 70% to decrease risk and facilitate the simpler transition in and out of a given stock.

6. The typical gain/loss statistic, incorporated with the wins-to-losses ratio, can help infer optimal position sizing and money management utilizing strategies like backtesting. Traders can take bigger positions and decrease commission expenses by boosting their average gains and boosting their wins-to-losses ratio.

7. Annualized return is utilized as a tool to benchmark a system's returns against additional investment platforms. It is significant not only to glance at the all-around annualized return but furthermore to take into account the increased or decreased risk. This can be achieved by glancing at the risk-adjusted return, which accounts for numerous risk characteristics. Before a trading system is acquired, it must surpass all different investment venues at equal or less risk.

8. Backtesting customization is incredibly vital. Many backtesting applications have input for commission percentages, round (or fractional) lot sizes, tick sizes, margin requirements, interest rates, slippage beliefs, position-sizing rules, similar- bar exit regulations, (trailing) stop settings, and much more. To get the most precise backtesting conclusions, it is vital to tune these settings to imitate them and utilize them when the system goes live.

9. Backtesting can sometimes steer to something recognized as over-optimization. This is a situation where performance outcomes are tuned so high to the past they are no longer as precise in the future. It is commonly a nice idea to execute regulations that apply to all stocks, or a unique set of targeted stocks, and are not optimized to the extent the regulations are no longer discernible by the creator.

10. Backtesting is not always the most precise way to assess the efficacy of a given trading system. Sometimes strategies that executed well in the past fail to do nicely in the present. Past performance is not denotative of future outcomes. Be sure to paper trade a system that has been incredibly backtested before going live to be confident that the strategy however applies in reality too.



Frequently Asked Questions

Q. How to analyze backtesting results?

Various performance parameters can be utilized to assess and analyze the backtesting results. Some of the performance metrics are Sharpe percentage, drawdown, annualized returns, and volatility. These metrics are examined in this blog. You can read more about the performance metrics in this blog.


Q. How to distinguish between good and bad backtesting outcomes?

To understand whether the backtesting results are good or bad, you require to test them. One of the means is to divide the dataset into training and test dataset. In the training dataset, you can develop and optimize the various strategy parameters. And on the test dataset, you can assess the performance.

If the strategy executes well on the test data, it is a clue that the strategy is promising. If the performance is sub-optimal, it is reasonable that you have overfitted the parameters and you require to re-analyze the model.


Q. What should be the duration for backtesting?

The duration for backtesting hinges on the typical holding period of your position. If you are trading a strategy with a holding duration of more than a month, then it is nice enough to utilize it for a longer duration, preferably around 15 years.

Q. How many stocks to backtest with?

There is no steady answer to this problem. But the strategy includes a diversified set of stocks that belong to various sectors. This is because if you only keep stocks from a specific sector, say technology. Then in situations like the Dot-com bubble,(Means Digital Evolution ), your strategy will be reprimanded. But such situations can be averted if you have a diversified portfolio. As you have to constantly keep on changing your strategies keeping in mind the market scenarios.

Key Decisions for Backtesting Trading Strategy

Select the right market/asset segment
  • There are several characteristics that you can look at, to decide a market or assets will be reasonably good for the sort of trading you are looking to execute. The characteristics can be risks you are ready to take, the revenues you are looking to earn, and the time for which you will be capitalizing, whether long-term or short-term duration.
  • For instance, trading in cryptocurrencies might be a riskier choice than others but can provide increased returns and vice versa. Thus, it is a significant decision to choose the correct market sector and asset class to trade in.


Data to cover the diversity of market conditions

  • The rates in a stock market are susceptible to many characteristics, and thus keep differing depending on the type of situation going on. These characteristics may comprise of main announcements like monetary policies, the release of the annual report of an organization, inflation rates, etc.
  • The key point to contemplate here is the fact that the market will not constantly behave likewise, and this is the rationale why we need to test the trading strategies on several stock market conditions so that we understand how the strategy will execute in those situations.

Incorporate trading expenses

It is significant to incorporate all sorts of commissions, taxes, and slippages while backtesting. Possibly, the strategy executes well without these expenses, but it drastically influences the emergence of a strategy’s profitability after the inclusion of these expenses.

Conclusion

Backtesting is undoubtedly one of the largest windfalls of Algorithmic Trading because it enables us to test our techniques, before actually executing them in the live market.

Backtesting is one of the most significant aspects of augmenting a trading system. If created and interpreted appropriately, it can encourage readers to optimize and enhance their strategies, discover any technological or theoretical drawbacks, as well as gain assurance of their strategy before applying it to the real-world stock markets.

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