Investing and trading isn’t just guesswork, there are strategies and software used to make sure an option is worthwhile. One of the things used to help with making decisions is called backtesting – but what is it and how is it used? This article will explain all you need to know about the basics.
The Theory of Backtesting
Essentially, backtesting is based on the theory that if something worked well or was true in the past, it will work again in the future.
Backtesting for Investing
In terms of use in a trading or an investment strategy, backtesting is used to financially analyse the success of a potential investment by using historical data.
It is important to make sure that the period of time selected to do the test is sensible and accurately reflects the possibility of success in the present. Picking a window of time that’s too far in the past, too short or too long may have adverse results.
Other Uses
Backtesting is not just used for investing and trading, it can also be applied to a number of different uses and industries…
Research
If used in a proper manner, backtesting is a valuable method to use when conducting research for a project. If a researcher has a theory, they can backtest that idea using multiple sets of data. For example, if the researcher is given a reason to believe that people in certain regions live longer than others, they’ll backtest previously gathered data to see if this is true and why.
For Business Strategies
Businesses can use backtesting to inform them of the possible outcomes of potential business strategies. For example, by using a combination of historical transaction data, a business can see how well certain products perform at certain prices.
Example: A clothing shop may look at past sales of jackets and how many they sold at £60 vs how many sold at another similar price such as £55, this could inform them of what price to set things at for the new season.
Business data tends to not age too well though, so backtesting price strategies against data from too far in the past won’t be of much use.
Best Software
Microsoft Excel was one of the first programs that was popular with traders to perform tasks like backtesting and build automated trade execution models. It is the old school way of doing things, so there are definitely newer, better and more efficient ways of backtesting now.
Some people use the computer programming language Python to do their backtesting, as it can be used to conduct data analysis and automate tasks. Python can also be used to build websites and software. It is a general purpose language which essentially means it has a lot of uses and can create a variety of programs.
It all depends on if you have any programming skills, if not there are various pieces of software that can be used by all different manners of skill sets…
Here is some recommended backtesting software:
- TrendSpider – Beginner friendly
- Trade Ideas – AI powered
- TradingView – Free software
- Ninja Trader – Free software
- MetaStock – Backtesting and forecasting combine
Drawbacks
Though backtesting is based on the theory of things that worked well before will work again, this isn’t something that is completely certain. Just because a backtest result shows a high chance of success, doesn’t mean it’s guaranteed to work in the real world, you can’t expect 100% accuracy as results won’t be identical.
Whilst you may experience some success, there’s always still a risk. Some things just can’t be predicted. Backtesting should be used in combination with other techniques and strategies, including forward looking indicators.
Is It Worth It?
Backtesting is an important and useful part of perfecting a trading strategy. It allows you to test various scenarios in order to assess the risks and level of profitability. Using that information will then help you to decide on the best and most balanced strategy to use. All this can be done before risking any money too.
Performed properly, and in combination with other methods, backtesting can make a big improvement to your trading performance.
