What Is Backtesting in Trading?
Backtesting is the process of testing your system, strategies, or just individual concepts on historical chart data. By testing ideas on past price movements, you can gain insights before applying them to live markets. However, it also has its flaws, and better alternatives exist that can significantly enhance your development.
How to Backtest?
Backtesting allows you to assess the effectiveness of something before using it in the live markets. You can test it, track the data, and optimise it.
To do this, you’re going to need access to historical data which most charting platforms are going to have. You simply go backward to a date in the past, then scroll the charts forward candle by candle testing whatever it is you’re trying out.
There are a few reasons why you should be backtesting things:
- Discover What Works (and What Doesn’t): Not everything will work as expected in the live markets. Backtesting helps filter out ineffective things, preventing you from wasting money.
- Build Skill and Confidence: Practicing your system on historical data helps you become more proficient. As you repeat the process, you'll notice patterns and improve decision-making in real-time trading situations.
- Boost Your Confidence: The more you practice using your system, the easier it becomes. Backtesting can help you gain familiarity with your strategies, so they feel second nature when it’s time to go live.
These are just a few examples. But the process of testing and improving our skill levels are important when it comes to learning to trade. Here some things to consider backtesting:
- Trading System: Run through your complete system repeatedly to optimise its performance.
- Strategies in Different Market Conditions: Test your strategies in various markets to see how they perform during bullish, bearish, and sideways markets.
- Skill Optimisation: Use backtesting to improve with individual concepts and tools.
The Downsides of Backtesting
Despite its advantages, backtesting has limitations. In a live trading environment, many factors come into play that historical testing can't fully replicate:
- Psychological Pressure: When real money is at stake, emotions such as fear and greed can heavily influence decisions. Backtesting doesn't simulate this aspect, making it easier to execute strategies in hindsight than in live markets.
- Overtrading: In backtesting, it's easy to keep pushing forward, looking for the next opportunity. However, real markets require patience. Waiting for setups can feel slow and lead to impatience after you’re used to jumping to the next opportunity..
- Limited Market Scenarios: Historical data can show specific setups and conditions, but it may not expose you to enough variety. Learning from real-time markets often involves implicit learning—understanding market nuances that aren't always visible in historical data.
Better Alternative to Backtesting
However, there is a better alternative, a trading simulator can be a game-changer.
Unlike backtesting, which is done on historical data without real-time interaction, simulators allow you to trade with real market data as if you were in live conditions. You can place trades, manage risk, and practice strategies with the same mechanics you'd use in live trading.
Trading simulators also offer the advantage of feedback. Unlike backtesting, where you might only record results after reviewing something, simulators track your performance in real time.
If you’re thinking about getting started on a simulator, I’d recommend checking out our video that goes into detail on the benefits and drawbacks of simulators, and even includes examples of what to practice on them.