What Is Backtesting? (With Definition, Examples And Tips)

Updated 30 November 2022

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Backtesting is the process of testing strategies against historical data. By performing a backtest on historical data, you can determine how well a model or strategy would have performed in the past and how effective it is on current data. If you are a trader or are planning to make an investment, backtesting can assist you in selecting effective strategies without risking your capital. In this article, we discuss what is backtesting, learn how it works and review some examples.

What Is Backtesting?

Learning what is backtesting and how it works can assist you in making better investment decisions and selecting strategies to maximise your profit potential. Backtesting is a method of analysing the performance of a strategy on historical data through simulation. When considering how well a strategy would have performed on a similar investment, investors are better able to decide whether to employ it in future investments.

Using backtesting, investors can experiment and compare various trading techniques without risking their capital. This technique is most commonly used in investment careers, but it is also beneficial for businesses and retrospective research in health care.

How Does Backtesting Work?

Backtesting involves selecting a representative sample of investment and collecting the relevant historical data. This strategy includes consideration of all available data, like financial reports and trading costs. By observing the potential results of applying a strategy to a reconstructed stock, investors can determine if their strategy is effective.

Backtesting assumes stocks move the same way they have in the past, despite the unpredictability of the market. This suggests that a strategy that performed well in the past on similar investments is also likely to perform well in the future. A successful backtest provides traders with a proven strategy that has consistently generated positive results and yielded profit.

Prerequisites For Backtesting

Consider the following factors before you backtest a trading strategy:

Learn the basic trading concepts

Before you backtest a trading strategy, you need a clear understanding of basic trading concepts, such as:

Ways to buy or sell a stock
Lot size or quantity of a stock
Strike price, stop loss and target price of a stock
Chart patterns and technical analysis
Fundamental analysis

Choose the right market for backtesting

To determine which market or asset is best for the type of trading you are planning, you can consider several factors, such as:

The amount of risk you can take in an investment.
The profit amount you hope to earn from your investment or trade.
The amount of time you are willing to devote.

Backtesting requires you to choose the asset class you wish to trade. Conduct thorough research on various types of investments and understand the risks of each asset class before you trade or consider investing. For instance, trading in cryptocurrencies can be riskier than other asset classes, but can also result in higher returns.

Consider the market sentiment

You can gauge the market sentiment to determine whether to buy or sell a stock. If the market sentiment is negative because of various reasons, such as geopolitical scenarios, financial reports of companies, uncertainty in the market or monetary policies, there is a high likelihood that you may not make a profit by buying a stock. If the market sentiment is positive, then you may consider buying a stock after evaluating other factors, such as chart patterns, technical analysis and trend indicators.

Collect data for backtesting

A backtesting strategy on an asset requires historical data, which contains the opening price, closing price and high and low of an asset in a particular timeframe. You can collect this data from data vendors or brokers. There are some websites that let you import data by using an application programming interface (API). You can then use various techniques to analyse this data and use existing strategies or formulate your own methods to perform a backtest. You can also train machine learning or deep learning models on a large dataset to predict the movement of an asset's price.

Rules For Backtesting Trading Strategies

Below are some rules to follow while performing backtests:

Examine broad market trends. When testing a strategy, examine the broad market trends and consider a longer timeframe to test your strategy. As an example, a strategy that has only been backtested in a smaller timeframe during an uptrend may not perform well in a downtrend.
Consider volatility measures. Developing a trading system requires considering volatility measures. Leveraged accounts are especially susceptible to margin calls if their equity falls below a certain point, which makes it necessary for traders to keep the volatility low and reduce their risk.
Manage your exposure. Market exposure refers to the amount of capital invested in the same industry sector. It is beneficial to keep exposure below 70% to reduce risk and make it easier to enter or exit an investment.
Calculate the annualised return. An annualised return compares the returns of an investment system to those of other investment venues. It is essential that a trading system outperforms other investment venues at the same or lower risk than other investment venues before an investment firm adopts it.
Customise your backtesting strategies. There are many applications that allow users to customise parameters such as brokerage charge, lot size, tick size, margin requirements and interest rates. Consider these factors before you test your strategy to estimate your returns in a trade or an investment.
Use paper trading to test your strategy. Backtesting may not always be the most accurate indicator of an effective trading system. It is important to backtest a system in paper trading to ensure that it remains applicable to live trading.

Advantages Of Backtesting

Here are some advantages of backtesting:

There is no loss of capital. In backtesting, investors test a trading hypothesis against historical data. This allows them to test different investment theories without risking their own money or that of their clients.
It is easier to test strategies. Frequent backtesting allows investors to continually adjust their strategies. They can accept or reject strategies based on the results of the simulation.
It helps choose an investment option. By using backtesting results, investors can make informed decisions regarding which investments to buy and sell. This can help them select a few primary strategies they can use frequently in an asset class.
It provides valuable insight. Backtesting is valuable for providing insight into why an investor implemented a particular trading strategy. Other investors can compare and modify their strategies to improve their performance.

Examples Of Backtesting

Here are a few examples of backtesting:

Example 1

Here is an example of an intraday trader in an investment firm conducting a backtest to determine a strategy that yields maximum profit:

An intraday trader works for a large investment firm that invests a large amount of capital into the stock market. This company wishes to test a strategy to determine whether buying a stock at its 30-day low can generate a positive return. The trader collects a wide range of historical data on previous stocks to apply this strategy to each of them.

When the trader applies this strategy to a set of historical investment data, the average return of this strategy is 60 points higher than that of the firm's current investment strategy. The firm uses this method in the future to maintain a positive return rate. They can modify the strategy if the return on investment reduces in the future.

Example 2

Here is an example of a team of traders in an agency conducting a backtest to determine an optimal strategy that maximises profit:

There are many investment strategies that a team of traders use when making investment selections. Their goal is to maintain a medium-risk level and achieve a high return by using various lesser-used strategies. To perform the backtest, they collect five years of historical data and apply various technical analyses and price action strategies, including financial reports and market sentiment of each year to determine the most effective strategy.

Using these techniques, they find that some of these methods yield negative returns. They continue to test these strategies until they find one that results in a profit of 50 points. They present their findings to the lead investor to make an informed decision.