What is backtesting

Backtesting is a key component of effective trading system development. It is accomplished by reconstructing, with historical data, trades that would have occurred in the past using rules defined by a given strategy. The result offers statistics to gauge the effectiveness of the strategy.

The underlying theory is that any strategy that worked well in the past is likely to work well in the future, and conversely, any strategy that performed poorly in the past is likely to perform poorly in the future. This article takes a look at what applications are used in backtesting, what kind of data is obtained and how to put it to use.

Some rules for backtesting

• Take into account the broad market trends in the time frame a given strategy was tested. For example, if a strategy was only backtested from 1999 to 2000, it may not fare well in a bear market. It is often a good idea to backtest over a long time frame encompassing several different types of market conditions.

• Take into account the universe in which backtesting occurred. For example, if a broad market system is tested with a universe consisting of tech stocks, it may fail to do well in different sectors. As a general rule, if a strategy is targeted toward a specific genre of stock, limit the universe to that genre; in all other cases, maintain a large universe for testing purposes.

• Volatility measures are extremely important to consider in developing a trading system. This is especially true for leveraged accounts, which are subjected to margin calls if their equity drops below a certain point. Traders should seek to keep volatility low to reduce risk and enable easier transition in and out of a given stock.