What is Backtesting?

How familiar are you with backtesting? If you're in the world of finance and investing, chances are you have heard about it. But for those who are new to the game, backtesting might seem like a mysterious and confusing concept. So, what exactly is it?

What is backtesting?

Backtesting is a method of evaluating the performance of a trading strategy or model by applying it to historical data and analysing the outcomes. The process involves simulating the execution of trades based on the strategy or model using historical data, and then analysing the results to determine the strategy's performance.

There are several steps involved in backtesting:

1. Define the investment strategy or trading rules: This includes identifying the assets to be traded, the entry and exit criteria, and any other rules that will guide the trade.
2. Select the time period for backtesting: This will typically be a historical time period for which data is available.
3. Collect data for the time period: This may include prices, volumes, and any other relevant data for the assets being traded.
4. Implement the trading strategy or portfolio: This involves applying the trading rules to the data to generate a series of trades.
5. Evaluate the performance: This may include calculating key performance metrics such as net profit, return on investment, and risk-adjusted returns.

Why should I backtest?

Backtesting can be used to evaluate the profitability, risk, and other characteristics of a trading strategy, and to determine whether it is suitable for use in live trading. It can also be used to optimise the parameters of a trading strategy, or to compare the performance against other strategies or models.

This form of testing is an important tool for traders, strategy developers and quants, as it allows them to assess the viability and potential performance of a trading strategy or model before committing real capital. However, it is important to note that backtesting results are not a guarantee of future performance, as market conditions and other factors may change over time.

There are several reasons why strategy developers or traders might want to backtest a trading strategy:

1. To evaluate the profitability of the strategy - By applying the strategy to historical data and analysing the results, strategy developers can determine whether the trading algorithm has the potential to be profitable in live trading.
2. To assess the risk of the strategy - Backtesting can help traders evaluate the risk of a trading strategy, by evaluating the potential for large losses or drawdowns.
3. To optimise the parameters of the strategy - By backtesting different combinations of parameters for a trading strategy, traders or developers can identify the optimal settings or rules for a strategy to perform at its best.
4. To compare the performance of different strategies or models - Backtesting can be used to compare the performance of multiple trading strategies to determine which one is the most suitable for a given set of market conditions.
5. To gain confidence in the strategy - By backtesting and analysing the results of a trading strategy, traders and developers can gain confidence in the strategy and to benchmark its performance when the strategy goes live, for further optimisation.
   

However, backtesting is not without its flaws, there are also some limitations to backtesting that should be considered.

Backtesting is only as good as its data

Backtesting is only as good as the data you are testing it against, if you are using incomplete or bad data the results will not be an accurate representation of how the trading strategy will perform. It can be subject to data limitations, such as incomplete or biassed data, and they may not accurately reflect the impact of market frictions, such as trading costs and liquidity constraints. In addition, backtests can be sensitive to the assumptions and parameters used, so it is important to carefully consider these when interpreting the results of a backtest.

Is backtesting worth it?

Overall, backtesting is a useful tool for traders, investors and strategy developers, as it allows them to assess the viability and potential performance of a trading strategy or model before committing real capital. However, it is important to note that backtesting results are not a guarantee of future performance, as market conditions and other factors may change over time. Consider using backtesting in conjunction with other tools and methods, such as forward testing and risk management, to provide a more complete picture of the strategy's performance and risk profile.