Backtesting: How To Backtest A Trading Strategy – Definition, How it Works, Analysis

What is backtesting, and how do you backtest trading strategies? And does backtesting a trading strategy work? In your day-to-day life, before you buy anything — a mobile phone, a house, or a car — you would want to check its features and history to know if it is worth your money. That also applies to trading, but here, what you check are your trading strategies. With a wide range of markets to trade, you need to backtest your trading strategies to be sure they work.

The steps involved in how to backtest a trading strategy include defining the criteria of the strategy, selecting the market and timeframe to test it on, loading up the historical data, writing the code and implementing the backtesting, and finally, evaluating the results.

A backtest is a tool that not only small retail traders use but also big institutions. The world’s most successful hedge fund, Jim Simons’ Medallion Fund, uses backtesting continuously to develop new strategies. Why? Because backtesting a trading strategy works!

Backtesting a trading strategy works because you can falsify or confirm a trading idea, you can automate all your trading based on the backtests, exploit the law of large numbers, limit behavioral mistakes, and lastly, you can save a lot of time in executions. Backtesting is not a waste of time! We have done backtesting daily for over 20 years, and this article summarizes the main reasons why you should backtest and why it works.