The Importance Of a Backtested Strategy
When it comes to trading the financial markets, backtesting and a backtested strategy should be your top priority.
A backtested strategy is one of the most accurate ways to assess how a particular methodology or trading strategy performs.
Just as importantly by backtesting you can obtain confidence in how a backtested strategy behaves.
Naturally you should be backtesting before deploying real capital.
This of course mitigates the risk to your hard-earned money.
A well-performed and successful backtest ‘almost guarantees’ consistent returns.
We say almost because nothing in trading the financial markets is guaranteed that is a guarantee.
A backtested strategy which arrives at positive yielded returns still needs to be implemented by a human more often than not.
You have two choices.
You can either use a backtested strategy supplied by a trusted educator and still undertake the backtesting yourself under supervision and guidance.
Or you develop your own trading strategy and backtest it yourself until you develop a backtested strategy that yields positive returns.
Backtesting your own strategy is a very difficult start to trading the financial markets for beginners.
So I would be advise you take this route when you have a solid understanding of backtesting and trading.
However, before all of that can be undertaken, it is imperative to understand:
What Is Backtesting and a Backtested Strategy?
As the name suggests ‘backtesting’ to undertake this type of analysis you must look back in time.
This is over historical price data.
In a nutshell, backtesting is a form of analysis of observing how a strategy and/or methodology would have performed.
Backtesting is completed by using historical data and/or charts for the data over a given time frame.
However, backtesting can serve to aid you in so much more than that.
With this approach to backtesting, 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, a given strategy and its effectiveness can be successfully compared and measured without any real risk involved, yet.
Accordingly, a positive backtested strategy instills much-required confidence and adjusts your mindset and expectations.
Conversely, a negative backtested strategy test highlights that a new plan must be adopted.
Tweaks are required to the rules before risking capital.
The backtested strategy must be completed again applying the new rules.
For all new traders, it is highly recommended to do a manual backtest of the trading strategy.
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 backtesting to get ‘their-eye- in’ on price behavior.
Equally, it helps them build their confidence which is much needed to be a successful trader.
To undertake a manual backtesting, traders must make these decisions beforehand:
- Choose the appropriate markets. For example; The Backtested strategy we applied to 10 currency pairs, Bund (German Bond) and Gold over 10 years on the 4 hourly and Daily charts. You can choose fewer markets and shorter time horizon than we did but we wanted to be confident in our strategy; The Able Method
- Ensure you have a complete set of rules and/or conditions. This requires a set of conditions or rules for your; Risk management, when you will enter and exit the trade based upon a set of predetermined conditions and criteria.
- Set up an excel sheet or similar. Record every trade that meets your set of conditions and your strategy criteria.
- Keep the future of the price chart of off your screen. So, you cannot see the future of price. Click the arrow on the bottom of your chart screen and navigate one period at a time keeping the future out of sight so you do not use hindsight analysis.
- Make sure you are completely thorough and honest when performing backtesting. 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.
- The focus should be on finding losses. You want to find why this backtested strategy will fail. Then if you can’t find more losses than winners you are onto a positive trajectory.
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.
Watch the Video How to Back test
Undertaking the Backtest
First things first, it is paramount to double check that all the chosen parameters (rules) 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 1-3 year.
4H Chart 2-5 Years.
Daily Chart 5-10 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.
Remember When Backtesting
Keep the future price off the screen so you cannot foresee the price outcome.
Once your strategy conditions have been 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%
(strike rate = how many times your trade was a winner versus loser)
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 Risk to Reward target of 2:1 present and you are right 50% of the time.
This will mean you will make money with this trading strategy.
The 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.
When Backtesting and Trading 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 strategy guarantees that their chosen approach is bound to be successful over the longer term if followed correctly.
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 strategy, you can always become a member of Able Trading.
We have a solid trading strategy. The Able Method backtested startegy has been backtested by multiple individuals and us.
We continue to trade the Able method successfully week in week with our members.
Become one of the Able!
Thank you for Reading.