{"id":6526,"date":"2020-11-25T05:58:48","date_gmt":"2020-11-25T05:58:48","guid":{"rendered":"http:\/\/algotrading101.com\/learn\/?p=6526"},"modified":"2021-05-12T13:39:51","modified_gmt":"2021-05-12T13:39:51","slug":"backtesting-guide","status":"publish","type":"post","link":"https:\/\/algotrading101.com\/learn\/backtesting-guide\/","title":{"rendered":"What is Backtesting? 3 Aims of Backtesting"},"content":{"rendered":"
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\"Performance
Backtesting Guide<\/figcaption><\/figure>\n\n\n\n

What is backtesting? Backtesting is the process of testing a trading or investment strategy using data from the past to see how it would have performed.<\/strong><\/p>\n\n\n\n

Understanding backtesting<\/h2>\n\n\n\n

Running a backtest<\/h4>\n\n\n\n

The general idea of a backtest is to run through stock prices in the past, usually with software, and hypothetically firing trades based on a certain trading strategy<\/a>.<\/p>\n\n\n\n

For example, let\u2019s say your trading strategy is to buy Amazon when it falls 3% in a day, your backtest software will check Amazon\u2019s prices in the past and fire a trade when it fell 3% in a day.<\/p>\n\n\n\n

The backtest results will show if the trades were profitable.<\/p>\n\n\n\n

Backtesting can be as simple as running analysis in Excel to something more complex such as creating custom backtesting software. It all comes down to your individual requirements.<\/p>\n\n\n\n

The 3 Aims of Backtesting<\/h4>\n\n\n\n

Backtesting accomplishes 3 things:<\/p>\n\n\n\n

  1. Shows if a strategy performs well in periods when it is supposed to, and vice versa<\/li>
  2. Provides an understanding of how the strategy performs in different markets.<\/li>
  3. Produces insights on how the strategy might be improved on.<\/li><\/ol>\n\n\n\n

    1. Performance during selected periods<\/strong><\/p>\n\n\n\n

    With a backtest, we can check to see if a strategy makes money when it is supposed to and loses money when it is supposed to.<\/p>\n\n\n\n

    For instance, let\u2019s say that our strategy is expected to perform better when the markets are volatile<\/a>, or in other words, when they move much more than they normally do.<\/p>\n\n\n\n

    If our backtests then show that we make more money than expected during less volatile periods, this is a red flag (even though we made money).<\/p>\n\n\n\n

    We need to examine our strategy and figure out why.<\/p>\n\n\n\n

    2. Understand how the strategy performs in different markets<\/strong><\/p>\n\n\n\n

    To gain more confidence over how consistently a trading strategy will perform, backtests can be run in different market environments.<\/p>\n\n\n\n

    This means running backtests with different stocks or other market assets.<\/p>\n\n\n\n

    It could also mean performing tests during periods where there are clear trends and comparing them to periods where there weren\u2019t.<\/p>\n\n\n\n

    3. Improving the strategy<\/strong><\/p>\n\n\n\n

    This involves making changes to a strategy after looking through the results of the backtest.<\/p>\n\n\n\n

    A common pitfall here is to continuously tweak the strategy so that it shows better results in a backtest.<\/p>\n\n\n\n

    This approach rarely leads to profitability when you trade it with real money and is known as overfitting<\/a>.<\/p>\n\n\n\n

    Why is backtesting important to you?<\/h2>\n\n\n\n

    Backtesting is an essential part of developing a trading strategy.<\/p>\n\n\n\n

    Pass, improve, or fail<\/h4>\n\n\n\n

    A backtest can help decide if a strategy is suitable to trade real money, can use improvement, or if it\u2019s best to give up on it.<\/p>\n\n\n\n

    Deploying a strategy<\/h4>\n\n\n\n

    As mentioned, backtesting helps us understand how our strategy performs in different market environments, this will allow us to deploy our strategy better.<\/p>\n\n\n\n

    A trader might have multiple strategies. By knowing the strength and weaknesses of each of the strategies, it will be clear when is it best to deploy a certain strategy.<\/p>\n\n\n\n

    Certain strategies pair well with others. Some strategies don\u2019t work well when market conditions are unfavorable. Running backtests will provide the information needed to decide when to deploy which.<\/p>\n\n\n\n

    What are some Backtesting Tools?<\/h2>\n\n\n\n

    There are several tools available to help you conduct a backtest. <\/p>\n\n\n\n

    A common way is to use a trading platform. <\/p>\n\n\n\n

    Trading platforms<\/strong><\/p>\n\n\n\n

    Popular trading platforms that include backtesting capabilities include QuantConnect, MetaTrader 4 & 5, Tradingview, ThinkorSwim, and Ninjatrader.<\/p>\n\n\n\n

    The benefit of using such a platform is that most of them include the necessary data. Several of them also have built-in analysis.<\/p>\n\n\n\n

    \"\"
    Performance summary of a backtest in Tradingview<\/figcaption><\/figure>\n\n\n\n

    Coding libraries<\/strong><\/p>\n\n\n\n

    As an alternative to using a solution tied to a trading platform, there are several coding libraries<\/a> that can help in backtesting.<\/p>\n\n\n\n

    For those familiar with Python, Backtrader <\/a>and Zipline <\/a>are both great options.<\/p>\n\n\n\n

    \n
    \n

    \nHere is our complete guide to Backtrader (Python):
    Backtrader for Backtesting (Python) \u2013 A Complete Guide<\/a>\n<\/p>\n<\/div>\n
    \n\n\n\n

    These libraries can accommodate a lot of customization. The trade-off is that the learning curve is a bit steeper.<\/p>\n\n\n\n

    \"\"
    Returns chart created in PyFolio<\/figcaption><\/figure>\n\n\n\n

    Analysis tools usually come with backtesting software. There are also third-party solutions available such as Pyfolio. This Python library simplifies creating charts and calculating statistics.<\/p>\n\n\n\n

    \"\"<\/figure>\n\n\n\n

    Backtesting software is not a necessity. The above image shows a chart that tests a hypothesis that gold prices rally for a few days after a Fed meeting<\/a>. <\/p>\n\n\n\n

    All it took was a simple\u00a0charting library<\/a>\u00a0and some historical data.<\/p>\n\n\n\n

    What are the 3 Backtesting Mistakes?<\/h2>\n\n\n\n

    It is easy to misuse backtests to develop a flawed strategy that looks good historically but fail in live trading.<\/p>\n\n\n\n

    Here are 3 common mistakes to be wary of:<\/p>\n\n\n\n