Backtesting

Backtesting is the technique of testing a model or strategy using historical data to study how the model or strategy would have performed if it had been used in the past. It involves a prediction about the past or how the model would have behaved or performed in the past.

It is essential in proving a system, model, or strategy. It is based on the belief that any strategy or model that functioned well in the past is likely to do so again. Conversely, any strategy or model that did not perform well in the past will probably repeat poor performance. However, backtesting is constrained by the need for extensive historical data since its use requires sufficiently precise simulations of previous events.

• Backtesting is the process of evaluating a model or strategy using historical data to see how it would have performed if it had been employed in the past.
• It can be used in different financial markets and primarily requires historical data only. However, collecting accurate historical data and setting the associated environment will sometimes be complex. 
• Many traders and analysts optimize their portfolios after backtesting stocks, currency pairs, and cryptocurrencies before making an investing decision.

Backtesting is testing a model on historical data or past trends. It can be done on particular stocks, forex currency pairs, or cryptos. Furthermore, when performed on multiple stocks or investments, it constitutes a portfolio backtesting to check the profitability of selective investment opportunities in a particular scenario.

The results or the outcome help traders take positions and make intelligent investments. It is helpful for traders, analysts, and investors and is most commonly done by trade analysts. When backtesting a portfolio, an analyst can gauge the returns they might have received in the past. If the analyst is interested in testing a long-term strategy, heavy data of weeks and sometimes months are required to initiate a backtest. Many advanced traders perform option backtesting to understand the expected returns and plan their future investments. The percentage return indicates the success or failure of an investment strategy. It is also possible to measure the average risk-reward ratio.

As the backtesting definition suggests, the few limitations of it are that it is completed based on past trends and historical data. Therefore, it is highly possible that it is prone to inaccuracy and does not guarantee future performance. Nevertheless, it is an intelligent tool. One of the key features is that it is not limited to stocks only and can be used in different financial markets or instruments like backtesting in forex, cryptocurrency, etc.

The backtesting in trading follows a determined process:

• Defining parameters: It is the first step to setting the parameters of any strategy before analyzing its results. No real money is involved, so there is no risk involved, but to test an investing technique, an analyst or trader must set its elements. 
• Spotting trades: The technique requires the analyst to look back at old trades and go back as far as possible to understand the initial market conditions; spotting trades from the past can give a brief outlook and develop perspective.
• Studying price charts: It plays a critical role in backtesting. Analysts must study long-term price charts and, most importantly, spot the difference, understand the pattern, and pinpoint the entry and exit signals.
• Determine gross return: The gross return is calculated, including winning and loss-making trades. It is done by recording all trades by an analyst and tallying them all. 
• Computing net return: The net return comes after the gross return, simply the value attained after removing all the commissions, trading costs, fees, and other associated costs considered in the gross return.
• Finding percentage return: The total return for the whole period is calculated and represented as a percentage. It is done by collating the net return with the capital required to initiate and support the strategy.

An investor can determine how the index product would have performed as an investment vehicle in significantly different market situations by backtesting it using historical data. For instance, it can indicate how an individual mix of stocks weighted in a specific way has reacted during a crisis like a dot-com bubble, the 2008 financial crisis, or an interest rate environment different from the current state.

If the index had been a traded product back then, backtests could help identify extreme circumstances where things could have gone disastrously wrong. In addition, it makes it possible to adjust the settings such that the optimum match may be obtained across a range of underlying market circumstances.

This article has been a guide to Backtesting & its meaning. We explain its example, how to do it, and compare it with forward performance testing & stress testing. You may also find some useful articles here -

• Algorithmic Trading
• Quantitative Trading
• Transaction Risk