And why is it so important?
Backtesting is an important step in optimizing a trading strategy as it assures the traders that the strategy is fundamentally strong and could yield profitable outcomes when implemented in the live market.
In this article, we will discuss the basics of backtesting, the difference between backtesting and forward performance testing, and by the end of this article, we will also backtest a few strategies using the Streak platform.
Backtesting is a popularly used step and an important tool in traders’ toolbox, without which it is risky to dive into the market. Think about it — be it a mobile phone, car, or any other product, we first check the history of the brand, features and then check if it’s worth your money. The same applies to stock marketing strategies.
Backtesting is a process of testing a trading hypothesis on a previous time basis, in simple words, backtesting is assessing the viability of a trading strategy using historical data to evaluate the profitability of the strategy, and how the strategy would operate in the live market. So if you have a trading strategy and are planning to go live, backtesting will help you reappraise the performance and potential outcomes of that strategy for a particularized period.
So how does backtest work?
When you have a trading strategy that abides specific criteria for entry and exit conditions of a trade, for a pre-determined period, a backtest will run that strategy for the period specified. The stocks matching those conditions (for the period specified from a group of stocks) will be put into your portfolio and a profit and loss statement will be furnished likewise.
This will help you evaluate the performance of the strategy without engaging any capital. You can choose to deploy the strategy in the live market based on the viability of the backtest result. Simply to say, you would have incurred similar results if you would have gone live with the strategy. Needless to say, past performance does not guarantee the future performance of the strategy, as it only presents only a predictive picture of how it could perform in the future.
How is backtesting different from forward performance testing?
Typically known as Paper trading, it enables a trader to evaluate the variability of the strategy in live market conditions (unlike for a predetermined — prior time in the case of backtesting) allowing the trader to validate the strategy for current market conditions without actually taking the trade positions. Paper trade is a trading hypothesis whereby, we replicate the live market trading with virtual money. It acts like a stock market simulator.
This is the backtest result of a simple VWAP strategy for educational purposes only*. I have deployed the strategy with a stop loss and target price of 1% each on a 1hour time frame.