Backtesting is a process of testing a trading strategy using historical data to evaluate its performance. In the context of stock trading, forex, or other financial instruments, backtesting allows you to assess how a trading strategy may perform in actual market conditions based on past data.
Performing backtests is crucial because it is the only way to assess the performance of a trading strategy before using it. This way, you don't have to risk a significant amount of money just to find out if your trading strategy is profitable or not.
Generally, after completing the backtesting process, you will know the performance of the tested strategy. However, you won't only get general data showing whether the strategy works well or not, but also more detailed data that can help you understand the characteristics of the trading strategy. Some of the data generated during backtesting includes:
1. Win Rate or Probability
The most anticipated outcome after backtesting is to see the probability of the tested method. This data represents the ratio of profitable trades to losing trades but does not account for the value of gains or losses for each trade.
This data alone does not always indicate whether the backtested method is profitable. To determine that, you need to consider the risk-to-reward ratio. For example, if the backtest result shows a 60% win rate, it means 60% of the trades were profitable, while the remaining 40% resulted in losses. However, this ratio does not necessarily show that the strategy will be profitable when used in real trading, as having more winning trades does not always result in greater profits than the losses incurred.
For instance, if you use a 1:2 Risk to Reward Ratio, where the risk is twice as much as the potential profit, even with a 60% win rate, you may still not be profitable, as the 40% of losing trades outweigh the gains. The actual probability of the strategy, in this case, would be 42% as per the following calculation:
100% = (40x2) (60x1)
100% = 80 60
100% = 140
Probability = (60 ÷ 140) * 100
Probability = 42.86%
2. Profit and Loss Values
The profit and loss values show the gains and losses generated by the trading strategy during the backtesting period. This information helps you gauge the potential profit and risk you may face using the strategy.
If you don't want to calculate the actual probability (after incorporating the risk-to-reward ratio), you can refer to this data to determine if the tested method is profitable or not. If the overall results show that the profits generated are greater than the losses, then the method is considered profitable.
However, it's also essential to evaluate if the strategy generates profits effectively. For example, if the profit achieved is minimal, such as only 500 pips over a 5-year backtesting period, it's advisable to look for another method.
3. Consecutive Win and Loss (Winning and Losing Streaks)
This data provides information about the number of consecutive winning or losing trades without any change in the trade direction. For instance, if there are 5 consecutive winning trades, it means there were 5 profitable trades without any losing trade in between.
This data helps you understand the trading patterns of a specific strategy and how consistent the winning or losing streaks may occur. It also helps you remain calm even during consecutive losses when trading with a real account, as you know the maximum consecutive loss limit based on the trading method you are using.
4. Drawdown
Drawdown measures the decline in equity or trading portfolio balance from its peak to the lowest point during the backtesting period. It represents the maximum potential risk you may face when using a particular trading strategy. Drawdown is a crucial indicator as it shows how much potential loss you may encounter before your portfolio starts recovering.
Drawdown can also serve as your overall maximum loss limit. Once this limit is reached, you should immediately stop trading and reevaluate both your trading approach and the strategy you're using.
5. Holding Period
Holding period refers to the time between the opening and closing of a trade. This data tells you how long, on average, your trade positions last before being closed. The holding period is essential to understand the trading patterns and how quickly or slowly your trading strategy generates profits or losses.
Information about the holding period of a trading strategy will be beneficial in evaluating whether a strategy aligns with your trading style or not. It also helps you remain patient while waiting for your positions to reach the profit target or hit the stop loss. This way, you'll be more disciplined in executing the trading plan you've established beforehand.
In conclusion, those are the essential pieces of information or data you'll gain after backtesting a trading strategy. This data is valuable as it provides comprehensive insights into the performance of the trading strategy during a specific period and helps you analyze and understand its characteristics. By understanding this data, you can make more informed decisions, especially when choosing which strategies are suitable for actual trading. Additionally, this data helps you gain a clearer picture of how your trading process will be, enabling you to adapt quickly to the chosen trading strategy.
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