The Importance Of a Backtested Strategy
When it comes to trading the financial markets, backtesting is one of the best ways to assess how any particular methodology or trading strategy performs.
A well-performed and successful backtest analysis almost guarantees consistent returns.
Furthermore, it also helps traders develop their confidence.
You can either use a backtested strategy or undertake your own.
However, before all of that can be undertaken, it is imperative to understand:
What Is Backtesting?
As the name suggests, to undertake this type of analysis you must look back in time.
In a nutshell, backtesting is a method for observing how a strategy and/or methodology would have performed.
This is completed by using historical data and/or charts for the data over a given time frame.
However, it can serve so much more than that.
With this approach, it is a vital step in creating a successful trading strategy.
This is because it allows traders to potentially foresee, with the help of past data, market movements under the boundaries of their chosen rules which make up the strategy.
That way, any given strategy and it’s effectiveness can be successfully compared and measured without any real risk involved.
Accordingly, a positive backtest instills much-required confidence and adjusts your mindset.
Conversely, a negative test signal highlights that a new plan must be made or tweaks are required before risking capital.
For all new traders, it is recommended to do a manual backtest.
This is because it aids them with how a price chart tends to flow on any given asset.
It is useful for the trader who is undertaking the backtest to get ‘their-eye- in’ on price behavior.
Equally, it helps them build their confidence needed to be a successful trader.
To undertake a manual backtest, traders must make these decisions beforehand:
- Choose the appropriate markets. For example; I Backtested 10 currency pairs, Bund(German Bond) and Gold over 10 years on the 4 hourly and Daily charts. You can choose fewer markets than I did but I wanted to be confident in my strategy.
- Ensure you have a complete set of rules and/or conditions. This requires a set of conditions for your; Risk management when you will enter and exit the trade based upon a set of predetermined conditions.
- Set up an excel sheet or similar. Record every trade that meets your set of conditions and your strategy criteria.
- Make sure you are completely thorough and honest when performing a backtest. There is no point curve fitting your results to suit a better outcome. This will only affect your real results and more importantly when your capital is involved could equate to losses. Ensure you treat every trade condition as you would if you were placing a real trade.
Once the backtested strategy is complete you should have a data set for your chosen markets.
This tells you whether your strategy is successful and ready to deploy. Or you need to make a few tweaks and re-run the backtest.
Undertaking the Backtest
First things first, it is paramount to double check that all the chosen parameters are set and you have undertaken the backtest correctly.
Once that is complete, it is time to move back in time over the data set.
How far back in time should you go?
That will depend on what each trader is looking to replicate.
I would suggest at a minimum:
1H Chart 1 year.
4H Chart 3 Years.
Daily Chart 5 Years.
You should start at your chosen time point.
Using the keyboard arrow keys to move forward in time until a trading opportunity presents itself.
Tip: Keep the future price off the screen so you cannot foresee the price outcome.
Once your strategy conditions are met to enter a trade, input the data into your spread sheet.
Use your spreadsheet to track how each of the trades performs.
Asset, Date, Time, Entry, Exit, Risk amount, Starting Capital, Target met, Win/Lose etc…
Repeat this activity until you have collected enough data to form an analysis of whether it is successful over your chosen data set time horizon.
For example, the strike rate may be running at 50%
Meaning, the strategy yields a winning trade 50% of the time over the given time horizon.
If your rule dictates that a trade can only be taken when you have a target of 2:1 present and you are right 50% of the time.
Then this will mean you will make money with this trading strategy.
This result equates to every winning trade winning twice as much as risked (2:1 ratio)
Therefore if you always win twice as much as you risk 50% of the time you will make money.
Remain Stoic In The Face Of Adversity
Completing a proper backtest to create a trading strategy gives any new trader the ability not to fold when the market has turned against them.
Remember, 5 out of 10 trades will be losers based on the above example.
Trades could present themselves randomly. 5 losers in a row could happen. Possibly more losing trades could happen given the 50% strike rate is over a long period and is an average statistic.
Could you take the 6th trade after 5 losers without knowing your trading strategy is solid from backtesting?
I doubt it.
A backtested trading strategy guarantees that their chosen approach is bound to be successful over the longer term.
Additionally, they also know when are the most likely times where their strategy is bound to generate losses and what to look for to make profits again.
To learn more about the backtested trading strategy, you can always apply to work with me. Contact me here