This video explains how to backtest your trading strategy step by step so that you get the best possible results from your backtest. Most people make the mistake of backtesting the wrong time of day. testing your strategy at various hours of the day instead of only backtesting when you are actively trading.
Backtesting allows a trader to simulate a trading strategy using historical data to generate results and analyze risk and profitability before risking any actual capital.
A well-conducted backtest that yields positive results assures traders that the strategy is fundamentally sound and is likely to yield profits when implemented in reality. In contrast, a well-conducted backtest that yields suboptimal results will prompt traders to alter or reject the strategy.
Particularly complicated trading strategies, such as strategies implemented by automated trading systems, rely heavily on backtesting to prove their worth, as they are too arcane to evaluate otherwise.
As long as a trading idea can be quantified, it can be backtested. Some traders and investors may seek the expertise of a qualified programmer to develop the idea into a testable form. Typically, this involves a programmer coding the idea into the proprietary language hosted by the trading platform.
The programmer can incorporate user-defined input variables that allow the trader to “tweak” the system. An example of this would be in the simple moving average (SMA) crossover system.
The Ideal Backtesting Scenario
The ideal backtest chooses sample data from a relevant time period of a duration that reflects a variety of market conditions. In this way, one can better judge whether the results of the backtest represent a fluke or sound trading.
The historical data set must include a truly representative sample of stocks, including those of companies that eventually went bankrupt or were sold or liquidated. The alternative, including only data from historical stocks that are still around today, will produce artificially high returns in backtesting.
A backtest should consider all trading costs, however insignificant, as these can add up over the course of the backtesting period and drastically affect the appearance of a strategy’s profitability. Traders should ensure that their backtesting software accounts for these costs.
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