Trading Toolkits: How to Backtest

An efficient way to test your strategy before use on the live trading market is to check its profitability through backtesting. Backtesting a strategy is a very important tool that allows a trader to test a strategy with no risk.

By
Wilfred Victor
on
April 11, 2021
Category:
Trading Toolkits

What is Backtesting?

Backtesting is an essential step to optimizing how you engage the financial market. It shows you how viable your strategy is. The purpose of backtesting is to show the validity of your trade set up and if they can turn a profit. 

The principle is in contrast with forward testing, which involves the use of paper trading. The idea is that historical price data may come into play in the future. However, it should be worth noting that what happened in the past may likely not happen in the future.


What to do Before Backtesting

Before engaging the Backtesting strategy, traders should do well to understand the type of traders they are or plan to be. For example, there are two basic types of traders;

  • Discretionary Trader: This type of trader uses market trends, fundamental analysis, and technical analysis. His strategy is not precisely measured as it’s not based on any system or metrics. Thus it becomes pretty hard to use the backtesting strategy with the discretionary trade setups.
  • Systematic Trader: Here, the trader relies on indicators to enter and exit trades. Trades are measured, and specific conditions for trading are to be fulfilled before engaging the market. Backtesting works best with this type of trader because of his ability to measure and keep data.


How to Backtest

There are two types of ways to Backtest a strategy:

  • Manual Backtesting: Involves the use of a manual approach to entering and storing data. A trader manually enters his data which includes
  • Entry
  • Exit
  • Stop Loss
  • Triggers
  • Date
  • Conditions for Entry
  • Screenshots of his trades ETC

The trader can make use of the Binance Backtest Spreadsheet as a template to create his own. The number of entries and type of data to be collected is not limited in scope. The trader can define his own rules and data types.

  • Automatic Backtesting: There are softwares available for use that can help keep track of data automatically. No matter your entries or data types, it can be coded into a program for use. The bot helps to study the behavior of a strategy, save and store it for future use.

Ideally, there is no hard and fast rule about which type of strategy a trader may decide to adopt between the Manual and the Automatic. It all depends entirely on the trader’s preference and choice.


The Significance of Backtesting

When done manually, backtesting can lead to a disciplined consistent effort in trading. Over time when a trader who uses the backtest principle moves to a live trading environment, he is already familiar with the trade environment and would be able to manage his psychology properly.

Appeal of Backtesting

Backtesting will help traders reduce emotions and view the statistics of their trading. Trading with your emotions engaged can lead to bad trade decisions. Backtesting will enhance discipline and help point traders in the direction of what's working and what's not.


The Weakness of Backtesting

Traders will have to stay true to the data entry and give little to no room for bias as that will cause them to get false results. If the backtesting is not done right it may lead to a much bigger problem in live trading. Any error or bias encountered in backtesting will result in an unprofitable strategy when used on the live market. For example, false back tested data is entered into a trading bot, it could mean huge loss for the trader.  


Concluding Thoughts

Backtesting as well as Paper Trading with Demo before going into a live trading environment should be the necessary first step for traders who want to stay solvent in the market.

The use of this tool allows traders to take on the market in a less stressful environment. Through exerting discipline traders can find an edge in the market and create a strategy around it. Overall backtesting gives traders potential to create elaborate trading strategies with minimal risk.

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Wilfred Victor

Ace finds himself as a blockchain enthusiast who is focused on growing with the entire crypto sector. He is an energetic and passionate writer who believes that all things are achievable.