Backtesting is a good way to check if your trading or investing strategy would perform well on a historical basis. Although past performance is no guarantee of future performance it is still critical to test all strategies before investing real money. Financial markets are very uncertain places where predicting price movements is extremely difficult and advanced testing and tweaking are required for every strategy. But it is also essential to avoid overfitting during the tweaking phase.
Let’s find out why you should always be testing your strategies and how to implement the best methods in this guide.
Basics of Backtesting on Popular Trading Platforms!
There are many ways investors and traders can backtest their new strategies and depending on the trading platforms they are trading on there are different methods used. Some of the advanced platforms offer trading simulation or other variations of backtesting. TradingView has an inbuilt replay feature that will require a paid subscription to use and offers a very good way of testing the strategies. Other platforms like MetaTrader 4 (MT4) come with free tools to test your strategies. Using a guide to backtesting on MT4 offers the necessary steps to test strategy and tweak its performance. The MT4 has an inbuilt strategy tester that can be used to test strategies on historical data. This method can come in very handy for trading robots and enable traders and investors to test their trading software within seconds. Another good method for backtesting used by many traders is to use Excel and write down all trades you would have made if trading on historical time frames. This way it is possible to test the strategy manually and is a bit time-consuming when compared to the MT4 strategy tester. To use testers you will need to gain a basic knowledge of a trading platform and then test your strategy. It is recommended to know MT4 or any other popular trading platform to make it much easier to trade and test. MT4 is one of the best trading platforms for trading robots that can be tested thoroughly with the platform’s advanced features.
Pros and Cons of Backtesting!
The immediate benefits of backtesting are obvious as it offers the ability to check if a strategy would be profitable in a historical period. But depending on your level of experience it is possible to get it wrong and overfit the data. This way the investors may insert parameters that are adjusted for a specific data set from a certain period which will increase the profitability of a strategy for that period and decrease the chances of its performance on live markets. As we have mentioned the financial markets are very uncertain and they are constantly evolving and changing. Because of this inherent nature, it is critical to generalize strategy and make it flexible.
Avoiding common mistakes during Backtesting can be key to successful trading performance. There are other important things to take into consideration including the ability to detect trends and ranges. Trend-following strategies are going to perform well during trending markets and range strategies are best for making profits when markets are in range.
Pros of Backtesting,
Despite having pros and cons, backtesting is still a cornerstone of trading and investing. Every investor has to test their strategies first before deploying them into live markets. Let’s first see why backtesting is beneficial to traders and investors.
- Helps find the best strategies that would perform well on historical data,
- Helps develop proper risk management strategies,
- Find out if the strategy can spot profitable setups,
- Clearly see the strategy weaknesses that need to be addressed,
Cons of Backtesting,
Here are some major backtesting mistakes that you need to avoid in order to develop a successful trading strategy.
- Overfitting – it happens when a trader changes settings to adjust for historical data the strategy being tested upon. This can lead to bad trading results in live markets as the strategy is limited to a specific period of time only.
- Past performance does not guarantee future success – strategy may show astonishing returns during the backtesting but it does not mean it will perform the same on live markets. Since markets are constantly adapting and evolving it is hard to find the best trading strategy that does not need constant monitoring and tweaks.
- Testing on a limited number of historical data resulting in false results.
- Pas performance is no guarantee for future performance, but it is still necessary to backtest every investing or trading strategy before launching in live markets.
- Many popular trading platforms like TradingView and MetaTrader 4 are offering advanced tools for strategy. testing and tweaking, while TradingView’s replay function is only for paid subscribers the MT4’s strategy tester is free.
- MT4 strategy tester is the best solution for testing the trading robots on historical data.
- Backtesting has both pros and cons every investor should take into account before testing their strategies.
- Backtesting the strategy provides a glimpse into strategy’s performance and shows key weaknesses and strengths of every strategy.
- Tweaking the settings too much can lead to overfitting where the strategy is only profitable on a certain historical period.