5 Reasons Why Backtesting Is Important
What Is Backtesting?
Backtesting is the most under-utilized secret weapon in trading.
It is the process of poring over historical price data and testing your strategy over hundreds or thousands of past trading opportunities in order to collect statistics about your edge.
Using a spreadsheet, the trader goes through price action one candle at a time and hunts for occurrences of their setup. Then they objectively track how the strategy would’ve performed over various market conditions or the past few years of price action.
With this data, they can then adjust their strategy to optimize their edge.
It’s an essential tool that many new traders don’t find out about or fully understand the importance of until late into their trading journey.
It is not a secret because successful traders don’t want you to know about it. All great trading mentors will tell you about backtesting.
It’s a secret because most traders don’t want to know about it.
It’s not glamorous. It’s not sexy.
Many people find it to be boring, monotonous, difficult, and worst of all, pointless.
They’ve been led to believe that backtesting doesn’t work or isn’t worthwhile, so they don’t bother with it, or they do a poor job of it, or they simply don’t respect the process.
But I disagree with that attitude completely.
Without backtesting I would not be here writing for this website. I would not be trading every day. I would not have lasted my test of time in the markets.
So without further ado… here are my top five reasons why all serious traders should take backtesting seriously.
1. Prove Your Strategy Works
I doubt I would have ever discovered any kind of system that worked without extensively testing it over historical data first.
For me, the amount of time it takes to forward-test (demo trade) strategies is extremely limiting. So when I am developing a new strategy I always turn to backtesting.
Through backtesting I can test multiple strategies across multiple markets within a single week. I could devise an entirely new profitable trading plan within a month or two if I needed to.
Backtesting allows you to collect massive amounts of data and information about your strategy with minimal time. Of course, it can take several hours to properly backtest a strategy across all relevant markets.
But that time is minimal compared to how long it would have taken to collect that data from live trades. Backtesting historical data allows you to witness how your plan would have theoretically performed had you been trading it for the past few years.
With this information you can objectively confirm whether or not what you plan to do in the markets will make you money, or lose you money.
You should be able to tell within 100 tested trades whether or not the strategy you plan to use is viable, but I personally shoot for 200-300+ trades per market.
Sometimes I end up with close to 1,000 tested trades per optimized portfolio depending on the timeframe.
If my strategy has a reasonable drawdown and a satisfactory return over that large sample size of trades then I know with confidence that it’s worth my time to attempt executing it on the live markets.
As I mentioned in my blog post What Is Trading Edge, the past is never an indication of the future, or at least not a consistently reliable one. But as traders confronting the unknown, it’s all we’ve got.
Through testing we can determine roughly what to expect when our strategy encounters a period of consolidation, or a trending market, a reversing market or even a flash-crash or high-volatility period.
This can help you to improve your future trading decisions, and as traders we need to take advantage of every opportunity to enhance and maintain our edge.
Without backtesting you are essentially trading blind.
2. Train Your RAS
If you follow my blog or you find this article interesting so far then I assume that you are a price action trader or at least a fan of technical analysis.
As technical traders our main talent is our ability to recognize trading opportunities (and danger) on our charts. Without that skill then nothing in the world could help us make money in the markets.
And how do you develop skills?
Through repetition and practice! Trading and technical analysis are no different.
On the one hand, as a trader a lot of what you do is objectively process-driven, such as risk management and journaling. These things are fairly straightforward and self-explanatory (for the most part).
All they require is the self-discipline to execute properly, which is different to your ability to recognize opportunities.
On the other hand, some of what you do as a trader is subjective. It requires pattern recognition. It requires attention to detail and knowledge of what to look for.
It requires discretion and a discerning eye that can tell the difference between a bear flag and a bull flag, or what zones are likely to cause a reaction to price, or where price is more likely to head next.
The only way you can develop this talent and skill is through practice. And trading the live markets with live money is not where you want to be getting that practice when you are new to trading.
Through backtesting you can train your reticular activating system to recognize patterns and occurrences of your edge much, much faster.
As Akil Stokes said in a recent podcast (which inspired me to write this blog post):
People ask all the time, “How long does it take you to look at a chart and know that you have a trading opportunity or not?”
And I say probably about ten seconds.
“How do you do it so quick?”
Well, because I know exactly what I’m looking for.Akil Stokes (Trading Coach Podcast)
3. Optimize Your Approach
My favorite part of backtesting is not so much finding a profitable strategy.
As I mentioned in the post 10 Untold Truths About Trading, there are thousands of profitable strategies. Finding a profitable strategy is not the most difficult part of trading.
The most difficult part is finding a strategy that works but is also compatible with your most persistent personality traits. My favorite part is finding the balance between profitability and comfort.
Through backtesting trading strategies you can painlessly determine whether or not a strategy is for you without losing any money in the process. Okay, maybe it won’t be painless, but it won’t cost you anything.
If you test a strategy over 200 trades and it returned 120% but at one point the account balance drew down 30%, then you may not want to trade it.
But someone else who is more aggressive might love a strategy like that and have no trouble trading it.
Or you find a strategy that returned 60% but only had a 5% max drawdown, so you decide it’s not unreasonable to double your position size.
Or perhaps you find a strategy that works great and you almost feel comfortable trading it, but you notice that it doesn’t perform very well during consolidation.
This is an issue I had with my strategy that I use presently. It wasn’t until I devised rules to define consolidation and then stopped taking trades during consolidation periods that the strategy became profitable enough for me to feel comfortable trading it.
Before then my testing results showed promise, but it wasn’t good enough. Through backtesting I identified its flaws and introduced new filters that increased its profit potential and reduced its drawdown.
I also identified that my strategy performs terribly on Mondays. After reviewing my testing and journaling results recently I realized that I have an abysmal win rate on Mondays. So I have now stopped trading my strategy on Mondays.
At the beginning of 2018 my mentor (Steven Hart) had to change his forex trading strategy rules.
He noticed that his trades were being stopped out too frequently on setups using a 1-ATR stop-loss, so he created a formula to calculate a slightly wider stop-loss on his trades.
He ended last year with a 152% gain.
Notice that the year began with a 20% drawdown, which exceeded his trading plan’s risk tolerance. Despite being stressed, he responded calmly, by backtesting heavily until he found a solution to the problem.
He didn’t just arbitrarily begin moving his stops back – he conceived potential solutions, then developed rules around those ideas, then verified that they had a positive impact on his edge through backtesting.
4. Generate Trading Ideas
One of the things that most attracted me to trading is the synergy of creativity with systematization.
I love combining my right-brain creativity to devise trading ideas and strategies with left-brain systematic rules, and then using a scientific approach to analyze the data… and then using creativity to revise the idea using that new information.
This is the creative process for nearly all creative endeavors. As a former musician I spent a lot of time writing songs, which required layering. I would start with a base idea and then build on it endlessly, and that was the fun part.
Not the final product, but the road to get there.
The strategies I use currently to trade were not ideas I had formed clearly in my head without a stimulating catalyst.
I discovered the strategies I use today while I was testing other strategies I learned from my mentor and a few ideas that he inspired. During my testing I noticed a bunch of repetitive patterns that caught my attention.
Some of those strategies worked, but did not exactly suit my psychology. Other strategies didn’t work, but by identifying why they didn’t work, I was able to turn that knowledge into an advantage.
Backtesting is like a mirror to reality. You might have the best trading idea in the world, but if you backtest it over 1,000 trades and it’s not profitable, chances are it isn’t going to suddenly start working now.
Likewise if you come up with a clever idea that you think probably doesn’t work, you may surprise yourself to discover through your backtesting that it in fact does work.
The strategy I currently use is basically a momentum pullback strategy. I buy and sell strong and weak markets into momentum. It’s not rocket science, and it’s certainly not special.
But it is a strategy that I sculpted to suit my personality and I am extremely comfortable with it – and I would have never discovered it if it wasn’t for the sandbox of backtesting.
With backtesting you can come up with an idea and then put it through the grinder. Whatever comes out is what you pay attention to.
This feedback loop allows you to tweak and perfect your approach until you find a set of filters and rules that not only work, but play to your psychological strengths.
5. Develop Sincere Confidence
Unless you work for a prop firm and you have a veteran trader with 10+ years of consistently profitable trading under their belt showing you the ropes, then you need to backtest.
Any confidence you have in your strategy is naive without backtesting.
Until it has stood the test of fire in live markets you have absolutely no clue how it is going to perform. So if you start trading it and you lose five trades in a row, is it any surprise that you feel distress?
Absolutely not! You’d be crazy if you didn’t.
If you haven’t backtested your strategy and it loses five trades in a row then you absolutely should be concerned – because who can say it won’t lose another 20 trades in a row?
However, if you had backtested the strategy yourself over a large sample size and personally witnessed it endure ten losing trades in a row and still come out the other end unscathed and profitable, then losing five trades in a row wouldn’t bother you very much.
Even though the experience would be unpleasant, you’d know full well that you have at least six more losing trades to take before you should become genuinely concerned.
Unless you are breaking your rules and not adhering to your trading plan, then you have nothing to worry about. And if you are breaking your rules or failing to follow your plan, it will stand out in contrast to your backtesting results.
If your backtesting results say you only had a 10% drawdown over a three-year period, and you encounter a 20% drawdown in your first six months of trading – you ought to seriously regroup and find out what is going wrong. That is not supposed to be happening.
But the only way you would know that it’s time to make a radical change is if you had backtested in the first place.
So don’t underestimate the power of backtesting.
It’s boring and monotonous, and hardly any trader enjoys doing it – but there are elements of every job no matter how fun or rewarding that nobody likes.
Success in life requires work, and backtesting is work. And if you do the right work the right way, you will find your job a lot easier.