Back Testing Your Trades

Trade Back Test

A trade back test is a historical analysis of the performance of a trading strategy by simulating trades using past market data. The purpose of a back test is to evaluate the effectiveness of a trading strategy by assessing its profitability, risk, and other relevant metrics. Below are key steps to performing a back test strategy:

Define the Trading Strategy:

A Trading Strategy needs to be defined and should be implemented based on the rules that is determined such as when to enter and exit trades, how much capital to risk per trade, and the criteria for selecting assets to trade. The trading strategy can be based on technical analysis or fundamental analysis.

Select Historical Data:

Select historical price data for the asset being traded and the time period to simulate the trades. The quality of the historical data used in the backtest will have a significant impact on the accuracy of the test results.

Set Up the Back-Testing Software:

Traders will need to set up a back-testing software platform that can simulate trades using the selected historical data and the trading strategy. The back-testing software will generate buy and sell signals based on the rules defined in the trading strategy.

Run the Back Test:

A Trader can run the back test using the selected data and the trading strategy to simulate trades and evaluate the performance of the strategy. The back-testing software will generate a report detailing the performance of the strategy.

Analyze the Results:

The Final step is to analyze the results of the back test & to evaluate the performance of the trading strategy and identify areas for improvement.

Below are 4 major benefits to performing a Trading Back Test:

1. A back test allows traders to identify the strengths and weaknesses of a trading strategy. By analyzing the performance report generated by the back-testing software, traders can determine which rules of the trading strategy were effective and which ones need improvement.

2. Back testing can help traders optimize the parameters of a trading strategy to maximize profitability. By testing different combinations of parameters, traders can determine which combination of parameters generates the most profit.

3. Performing a back test can help traders build confidence in their trading strategy. By simulating trades based on historical data, traders can evaluate the effectiveness of the strategy without risking real money.

4. A back test can help traders determine the effectiveness of a trading strategy. By comparing the performance of the trading strategy to a benchmark, traders can determine whether the strategy is worth pursuing.

Back Testing Examples

Two Examples on how to perform a back test includes using the Moving Average Crossover Strategy & the Mean Reversion Strategy.

1. The moving average crossover strategy is a popular technical trading strategy that involves using two moving averages to generate buy and sell signals. The strategy involves buying when a short-term moving average (e.g., 20-day) crosses above a longer-term moving average (e.g., 50-day) and selling when the short-term moving average crosses below the longer-term moving average. The steps to performing a back test for this strategy involves using a 20-day and 50-day moving average to generate buy and sell signals. A buy signal is generated when the 20-day moving average crosses above the 50-day moving average, and a sell signal is generated when the 20-day moving average crosses below the 50-day moving average. Traders need to select historical price data for the asset being traded and the time period to simulate the trades.

2. The second example is to test the Mean Reversion Strategy. The mean reversion strategy is a trading strategy that involves buying assets that are undervalued and selling assets that are overvalued. The strategy involves using technical indicators such as Bollinger Bands, Relative Strength Index (RSI), and Moving Average Convergence Divergence (MACD) to identify assets that are deviating from their mean values. Here are the steps to performing a back test for this strategy. The mean reversion strategy involves buying assets that are undervalued and selling assets that are overvalued based on technical indicators such as Bollinger Bands, RSI, and MACD. Traders need to select historical price data for the asset being traded and the time period to simulate the trades.

As in both examples, traders will need to set up a back-testing software platform that can simulate trades using the selected historical data and the mean reversion strategy. Traders need to run the back test using the selected data and the mean reversion strategy to simulate trades and evaluate the performance of the strategy. Traders need to analyze the results of the back tests to evaluate the performance of the either trading strategies and identify areas for improvement.

Conclusion

It is ideal to perform a trading back test whenever a trader develops a new trading strategy or modifies an existing strategy. A back test can help traders evaluate the performance of the strategy using historical data and identify areas for improvement. Additionally, traders may perform regular back tests to optimize strategy parameters and assess the ongoing effectiveness of the strategy.