What is Backtesting? Its Meaning, Benefits and Drawbacks
Backtesting is the process of testing a trading strategy using historical market data to determine how it would perform. Traders can use the technique to test and compare various trading strategies and employ successful strategies according to their needs. Back testing is an essential skill for individuals who want to regularly trade in the stock market. This article explains what is backtesting and its importance for investors.
Key Highlights
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Backtesting involves using historical data to evaluate the efficiency of a trading strategy.
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Proper backtesting requires high-quality historical data, insights on trading costs, and paper trading to refine the strategies.
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Inability to predict future market changes, and ignoring psychological factors that impact trading decisions are some limitations of backtesting.
What is Backtesting in Trading?
Backtesting is a technique used in trading to analyse the performance of a trading strategy or using previous market data. It involves implementing predefined rules and parameters for historical price data. On the basis of these metrics, traders check how the strategy might have performed in the past.
Backtesting is a very useful tool. It can offer valuable insights regarding trading strategies. It can help you find out whether a strategy has the potential to generate returns. In addition, it allows you to improve your strategy, identify its key weakness, and make better decisions while trading.
How to Do Backtesting in Trading
Now that you know the meaning of backtesting, let’s find out how you can do it. To backtest a strategy follow the below steps.
1. Define parameters: First, determine the parameters of a strategy before evaluating its results. There is no risk as you don’t have to use real money. You can employ any parameter of your choice.
2. Identify trades: The process requires you to check previous trades to understand the original market circumstances. You should go as far back as possible. Identifying trades from the past can provide a quick overview.
3. Analyse price charts: Backtesting heavily relies on the analysis of price charts. You must analyse long-term price charts to identify patterns and accurately find the entry and exit signals.
4. Evaluate the results: Use the results you obtain to assess the performance of a trading strategy. Calculate the important performance metrics like profitability, risk-adjusted returns, win rate, drawdowns, etc.
5. Refine the strategy: Analyse the backtesting data to identify areas for improvement. To improve performance, adjust the strategy's parameters, rules, or risk management techniques.
6. Validate the strategy: After making the necessary changes, validate the trading strategy. Run more tests on other data sets or time periods to find their reliability and consistency.
Time Period for Backtesting a Trading Strategy
Two factors play a vital role in determining the period to backtest a particular trading strategy. The two factors are the average holding period and the type of strategy used.
Average Holding Period
The holding period can be divided into 3 categories. The period will vary for each category as mentioned below.
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Long-Term: If the strategy entails holding positions for over a month, a 15-year period is suitable for backtesting. The long term frame enables a complete evaluation of the strategy in many market cycles.
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Short-Term: You can have a 10-year backtesting period for strategies with a holding period of less than a week. This time frame gives sufficient data to assess the strategy's performance in short durations.
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Intraday: A backtesting period of 3 to 4 years is suitable for strategies with a holding period of less than a day. This timeframe allows traders to analyse a strategy's performance and results under various intraday conditions.
Strategy Type
The appropriate period to backtest a particular strategy will also depend on the type of strategy you want to use. The suitable periods for different trading strategies are as follows.
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Trend-following: Traders require a large amount of historical data to evaluate a trading strategy across various market cycles. This is because trends can continue for a long time. In such instances, a ten-year period is appropriate.
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Mean reversion: The duration of backtesting for the mean reversion strategy depends on the timeframe. A short timeframe may require a few years of data. However, a long timeframe may require a longer historical period to properly analyse the behaviour of mean-reversal.
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Volatility-based strategies: Strategies that depend on market volatility, such as volatility breakouts or volatility-based position sizing need a different approach. Choose the backtesting period based on the amount of market volatility. When the market fluctuates often, having a larger historical period is advantageous.
Advantages and Disadvantages of Backtesting
Backtesting is quite beneficial for traders. However, it also has some limitations. Here is a table that lists the key benefits and drawbacks of backtesting.
| Feature | Advantages | Disadvantages |
|---|---|---|
Risk & Profit Analysis | Evaluate the historical performance of a trading strategy to assess its potential risks and profitability. | Past performance may not ensure future results as market conditions may differ from historical data. |
Capital Allocation | Prioritise capital allocation by identifying strategies with better risk-adjusted returns based on backtesting results. | Backtesting may not include transaction costs and slippage. They can impact real-world performance. |
Strategy Refinement | Identifying potential weaknesses in a trading strategy, allows you to improve it. | Strategies are designed to fit historical data which may fail to assess new market conditions. |
Data Quality | Backtesting needs high-quality historical data. It helps identify potential data gaps or inaccuracies providing wrong results. | Strategies cannot be developed solely based on backtested data used for training. This can lead to data dredging. |
Conclusion
Backtesting is a strategy that uses historical data to analyse the performance of a trading strategy. Traders have to use the information on past market conditions to backtest a strategy. It is an effective tool to identify the potential weaknesses and improve their trading strategies. Backtesting is quite helpful in developing a good trading strategy. However, it also has some limitations too. It may not accurately predict the changes in future market conditions. Hence, understanding the benefits and drawbacks is essential for traders to effectively use backtesting while trading.
Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.
FAQs on Backtesting
What mistakes should you avoid when backtesting a strategy?
While backtesting a strategy you should avoid mistakes such as employing insufficient data samples, exiting a trading system early, etc. These mistakes can give inconsistent results leading to wrong decision-making.
What is the difference between in- and out-of-sample testing?
In-sample testing uses past data to build and refine a strategy. On the other hand, out-of-sample testing analyses a strategy's performance on a different dataset.
How many stocks should traders use to backtest a strategy?
There is no specific number of stocks to use for backtesting. However, traders should use a wide range of stocks from different sectors.
How do transaction costs affect backtesting results?
Transaction costs can significantly affect backtesting results since they reduce the profitability of a trading strategy. If backtests fail to consider these expenses, the calculated return will be inaccurate.
What are some common backtesting metrics?
There are several metrics used in backtesting. The most popular ones include net performance, positions, profit and loss, loss and return standard deviation.
