Backtesting for beginners

How important is it in trading?

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DEFINITION

Backtesting

There are so many variables to consider when you make a trade, which is why you need to have a detailed trading plan in place before you think about beating the markets. This will help you stay objective and disciplined rather than succumbing to your emotions and potentially losing a lot more money than you’re comfortable with.

If you want to gain some reassurance that your strategy is worth following before you actually risk your own money, you can try backtesting it. This means seeing whether it was profitable in the past by playing it out against historical data, helping you determine whether this is a strategy worth pursuing. There is specialised software that can do this for you, or you may prefer to conduct backtesting manually

So, is this something beginners need to get on board with?

Many people believe backtesting is a must, such as chartered accountant Andrew Wilson who was recently in conversation with us. He said: “Build your edge in trading over time by doing backtesting work. Otherwise, it's a gamble.”

Although it’s a method that may give you extra confidence to take your strategy forward, a successful backtest doesn’t mean you have a 100% profitable trading plan. Especially given that backtesting doesn’t account for sudden, market-shaking events (it would never have foreseen the GameStop short squeeze in January 2021, for example).

What’s more, backtesting is incredibly time-consuming and there are certainly quicker, simpler ways to test out your trading plan.

Does backtesting really work?

Backtesting works under the assumption that a trading strategy that worked in the past will perform similarly when employed again. If you want to test your strategy against real-life data to give you more confidence to employ it, backtesting can help you decide whether to give it a try or go back to the drawing board.

  • However, a successful backtest does not guarantee a strategy’s future performance so you should never rely upon it exclusively. It’s also very easy to skew the data and end up with ‘hindsight bias’.

  • For example, if you keep amending your strategy to find the largest profit based on the historical data, you’ll ruin it by customising it for the specific conditions of the backtesting period. This means the strategy won’t perform in the same way if conditions change.

All in all, backtesting can be useful if you want extra reassurance before putting your trading plan into action. But it definitely isn’t mandatory and won’t guarantee returns either. In fact, rather than turning to weeks, months or years worth of historical data, testing a strategy in real-time market conditions will probably be more reliable.

TESTING YOUR TRADING STRATEGY

Is backtesting the only way?

Backtesting does have its perks. Looking back at past market activity will help you develop your understanding of price movements for the asset you’re trading, while a data-driven approach like this may also encourage you to practice self-discipline and critical analysis.

That being said, backtesting is also complex and takes a lot of time. Not all trading platforms offer the ability to backtest effectively, and attempting to do this yourself will be challenging — especially as a beginner. The last thing you want is an extra complication that could actually end up being more of a hindrance than a help.

TRIED, TESTED, TRUSTED...

An alternative? Backtested trading signals

Backtesting can be extremely valuable but it is also likely to be daunting for any beginner. Luckily, trading with us here at Trade Nation means you don’t need to spend the time and effort learning how to do this yourself. That’s because we offer trading signals from a leading, regulated, award-winning provider. Why does this matter? Every single one of these insights is tried and tested by a trustworthy expert.

All our trading signals come from Signal Centre, which we have partnered with because it’s the only major trading signal provider that has FCA authorisation and regulation. This ensures it meets all of the organisation’s strict standards, so traders can always trust that these insights come from unbiased professionals. Whenever you receive a signal alerting you to a trading opportunity, you can be confident that this insight has been back tested, forward tested (run on out-of-sample data to test against different market values) and adjusted before being shared.

While we must reiterate that this doesn’t mean the signal will be foolproof and you may still experience losses, these trading signals can provide useful guidance as you refine your strategy. And if you have a trustworthy, regulated source backtesting on your behalf, that frees out time and energy you can spend learning and improving as a trader.

THE MAIN PROBLEM WITH BACKTESTING?

Backtesting doesn’t account for breaking news

Markets can and do often follow trends, but the main flaw of backtesting is the absence of real-time, market-shaking events. Backtesting will not account for, say, a country suddenly dropping a nuclear bomb or a coup d'état. We’ve already mentioned GameStop — how could a quantitative method ever have predicted the events that unfolded on Reddit and the impact these would have on the markets?

When the data gets it wrong

Life is unpredictable by nature and markets are sensitive to major events. That means there’s always a chance of something happening that backtesting algorithms won’t expect. We’ve seen this play out in recent history with monumental, unforeseeable results:

The 2010 ‘flash crash’:

On 6th May 2010, the New York Stock Exchange saw the biggest stock market drop in decades, which became known as the ‘flash crash’. Over the course of 20 minutes, there was a near 1,000-point dive in share prices, with the Dow Jones dropping almost 9% and major companies like Procter & Gamble and General Electric losing hundreds of billions of dollars from their share prices. This was short-lived and the market recovered somewhat, eventually closing 3% lower.

The reason for this?

According to an official report by the two main US regulators, a $4.1bn (£2.7bn) sell order instigated by US mutual fund Waddell & Reed was said to be responsible. The firm had used an automated algorithm trading strategy to sell contracts called e-minis. As the largest change in the daily position of any investor that year, other traders were spurred on to sell — sometimes at “irrational prices”. 2bn shares worth $56bn had changed hands prior to the share prices returning to pre-crash levels.

The Long-Term Capital Management bailout:

Long-Term Capital Management was a huge hedge fund regularly boasting spectacular annual returns (40% in 1995 and 1996). Its investment strategy was based upon hedging against a predictable range of volatility in foreign currencies and bonds. In August 1998, Russia announced it was devaluing its currency and had defaulted on its bonds. However, this was more significant than what LTCM had estimated...

The result?

The Dow Jones Industrial Average had dropped by 13% by the end of the month. This pushed investors to turn to Treasury bonds, leading to a fall in long-term interest rates which boded incredibly badly for LTCM. It lost 50% of the value of its capital investments and almost collapsed. If the fund hadn’t been bailed out by the banks, this would have triggered a global financial crisis.

Always keep up with the news cycle

These examples show that a quantitative approach to the market will not always serve you well as unexpected events can impact the markets in ways a backtest would not expect. This is why you always need to have an eye on the news cycle.

Here at Trade Nation, we enable you to do this by offering alternative data through our exclusive Smart News feature

  • This scans social media and harvests all financial market news as soon as the stories break.

  • With all these developments in one place, you’ll immediately be able to spot developments relevant to your interests, and use this information to inform your trading.

Trading in real time

If you receive a significant notification through Smart News, it would make sense to make a well-informed trade based on your strategy regardless of whether you have backtested it or not. This is arguably a more accurate test too because while you perform a backtest with total objectivity, trading is not like that in real life. Trying your strategy out in the markets means you’re performing in real market conditions, using real money, with real emotion.

The result should help you understand whether your strategy is viable or whether you need to make some tweaks. Of course, remember to stick to your trading plan no matter what and only risk money you can afford to lose. Also make sure you employ risk management techniques, such as placing stop orders and limiting your potential losses.

Why learn to trade with Trade Nation?

Hopefully, now you understand why backtesting is so useful when it comes to establishing a trading plan you’re confident in following. However, there’s lots more to learn if you want to become a successful trader, and Trade Nation is the perfect place for you to do so!

As well as providing you with a selection of helpful educational resources, we offer a trading platform that’s easy to use and includes all the tools and features you need, without any unnecessary distractions.

We’re here to guide you every step of the way. Sign up for a one-to-one walkthrough so you know how to get the most out of the Trade Nation platform, and get in touch with our dedicated Customer Success team whenever you need some extra assistance.

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Financial spread trading comes with a high risk of losing money rapidly due to leverage. You should consider whether you understand how spread trading works and whether you can afford to take the high risk of losing your money.