Backtesting in trading

Backtesting is the process of assessing how well a trading strategy or analytical method could perform, based on historical data. It is a key component in developing an effective trading strategy. There are infinite possibilities for strategies, and any slight alteration will change the results. This is why backtesting is important, as it shows whether certain parameters will work better than others.

To backtest, a trading strategy is required. At minimum, a trading strategy helps to define entry and exit points for both winning and losing trades, plus a position size. In addition, a trading strategy will often provide context, such as defining if and when trades should be taken. For example, only when the price is above or below a moving average, or during the first hour of the day.

Backtesting can be a simple or complex process, and traders may use either automated or manual testing. The former requires automated software​​ that searches for trades that meet the strategy criteria, then adds up the winning and losing trades to show if the strategy was profitable over a specified amount of time. Manual backtesting refers to a process where traders analyse past trades based on their strategies, and then add up the results themselves.

There are several steps to manually backtest a trading strategy or model. Backtesting requires historical data, which shows past price movements of a particular asset from trading charts. To backtest, a trader will typically need several weeks of historical data for strategies where the trades are short-term in nature. Many years of historical data may be required if testing a long-term strategy.

Here are some basic steps that you could take when carrying out a manual backtest:

Technical indicators​ work well for backtesting because they provide specific readings at a given time. For example, if a trade is taken when the relative strength index (RSI) moves above 25 after being below the figure on a daily close basis, and the trade is taken at the following open, this is a very specific signal and can easily be tested, assuming that the exit is equally precise.

Backtest indicators can include the levels or signals that will trigger an entry or exit for a trade. Typically, this is an objective time, like a close or open following the signal, which helps avoid any confusion as to when the trade should be taken. There are a number of technical indicators available on our trading platform that could be used to backtest a trading strategy or model. Popular indicators for backtesting include Donchian Channels, Ichimoku Cloud and Heikin Ashi.

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As always, there is no definitive ‘best' technique when it comes to trading within the financial markets. The best backtest strategy will depend on your trading personality, overall goals and level of experience. Below are two methods that you could consider using as part of a backtesting template.

A trader interested in how to day trade​​ can manually backtest intraday charts. The simplest backtest includes looking at one-minute or five-minute chart timeframes, for example, of the asset being traded. You could find prior trades based on that strategy and then add up the profits and losses, which would provide an idea of the profit produced that week.

Whereas backtesting requires finding trades based on historical data to evaluate its future performance, forward testing is the process of simulated trading, where you “paper trade​” a strategy in live conditions. This requires the trader to watch the market in real-time, taking the strategy entry and exit signals as they occur.

Backtesting lets a trader know whether a strategy has profit potential, while forward testing helps to confirm or refute this. Forward testing (also known as walk forward optimisation) is also slower because it needs to be performed in real time. Each day is traded as it comes, whereas with backtesting, a trader can arrange years’ worth of historical trades in a single day, if desired.

Backtesting and forward testing can be used together to give a more complete picture of how a strategy performs, both historically and in real time.

Manually backtesting in forex works the same as in other financial markets. However, as the forex market is open 24-hours per day during the week, you need to be certain to only backtest during times of the day that you can actually trade. Backtesting a forex strategy over a month and using all hours over each day is unlikely to provide reliable information, unless automation is involved.

Before backtesting, consider the time of day you will be able to trade. Perhaps you can only enter trades within a three-hour window. When backtesting in forex, you only need to record entries and their resulting profits and losses that occur during the trading window.

Backtesting can be a useful tool when you are hesitant to put a strategy into action straight away. However, there are still a couple of pitfalls to consider.

Automated backtesting requires backtesting software, which may be available for free on some platforms, but it can come with a cost. Automated backtesting requires clear rules that a computer can understand. This may require some coding knowledge or software that allows you to input the strategy criteria.

Automated software is not required to assess the validity of a strategy using backtesting or forward testing. All that is needed is a demo or live trading account on our platform. After registering for our free backtesting software, you will have access to historical data on all chart timeframes, markets and assets, and a wide array of technical indicators to manually test nearly any trading strategy.

We also offer an inbuilt backtesting tool that relates to trading patterns. Our price projection tool is designed to help traders spot the direction of price action by measuring historical performance for each trading pattern. Learn more about this in our section on useful trading tools​​.

You can carry out both manual and automated backtesting using our MetaTrader 4 platform, using the required assets and timeframes. However, as creating an automated strategy in MT4 requires programming skills, many traders prefer to manually backtest their trading strategies, as this helps to build knowledge and skill within the financial markets.

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