backtesting

What is Backtesting and how you can use Historical Data to test and support your Trade Ideas.

Overview

Whether you’re new to Trading or a seasoned professional, Backtesting is something every trader must do in order to test their Trading System to ensure profitability. Different Trading Systems will require different approaches to backtesting, but the overarching premise is the same for all. 

Backtesting is the name given to testing a Trading System on historical price data, and evaluating how well a strategy would have performed. This often gives Traders the confidence to take the strategy forward and use it within the live markets. The theory is that if a Strategy is proven to work in the past, then it’ll work in current markets, and continue to do so in current markets.

In order to access this past price data for when you’re backtesting, you’ll need to have some form of software to access the Markets. One of the most popular these days is TradingView owing to its modern design and ease of use. However some prefer to use MetaTrader 4 & 5 as it allows greater functionality for EAs and Trading Robots. 

Why should I backtest?

You may be wondering: ‘Why should I spend time Backtesting if others are using the same strategy as me and it works for them? Surely it works and I don’t need to test it?”

Backtesting isn’t just to check if the strategy works or not, it’s to allow you to get accustomed to the rules of it. When you see a trade setup present itself, you want to know if its High Quality; how and where to place your Stop Loss, How to Enter, where to exit or remove profit and how to read price in relation to the direction of your Trade.

In order to know the Ins and Outs of your Trading System, you need a plan within which is the criteria for your Strategy. We recommend using a checklist with all the bits of information that you need to know before entering or rejecting a setup. These can be boiled down to the following:

  1. What are the Market Conditions needed to validate your setup?
  2. How much are you going to risk per trade?
  3. Which Markets are you Trading?
  4. What is your entry trigger to enter a trade on the setup?
  5. What timeframe do you analyse on, enter on and monitor on?
  6. Where will your Stop Loss be?
  7. How will you exit or remove profit from a position?

Backtesting Strategies

So, we’ve covered why you should backtest, now we’ll take you through how you can backtest on different software platforms. 

TradingView: 

This is one of the easiest pieces of software to use and Backtest with, especially if your strategy is rules based and not in the form of a Robot or EA. TradingView gives you the functionality to take price back to any point in time and play it from there as if it was happening in real time. 

These steps give you a rough outline of how to Backtest in TradingView: 

  1. Choose the Market you’d like to conduct the Backtesting on
  2. Use the Chart Tools to plot all the necessary tools to fit your Strategy, when you see price entering your High Value Area.
  3. Ask yourself if there’s a High Quality Setup at this point in the chart
  4. If yes to the above, mark out your setup in accordance with your plan and record the results of your trade in Journaling software or Excel
  5. Now continue to play price forward till you find more setups which meet your plan. 
  6. Rinse and Repeat this process till you have over 100 trades for each/any of your systems. This is the lowest amount of trades needed to gauge the profitability of a system. 

Backtesting Software:

There’s plenty of paid software you can use to backtest your systems and strategies, however they are all essentially the same thing once you peel back the advertising. Some of the most popular include Forex Tester 4 and AmiBroker. Both of these pieces of paid software are powerful in the fact that all you need to do is input your system parameters and click a button, and they’ll test the strategy for you. 

This being said, they are pretty complex, and take some form of coding knowledge to use with any ease. We would recommend you use TradingView or MetaTrader4 to backtest your strategies as this is how you’ll be trading in the live markets, and it allows you to see how your strategy performs with hands on involvement (which is as close as you can get to trading the live markets, without actually doing it).

How to record your Backtested Trade Ideas

We’d recommend using TradingVault, an online journaling software which allows you to record all your trades with ease and calculates all the metrics you could ever need. Check them out at https://trading-vault.com/?via=jake19 !

However, if you’d like to create your own journal, there are a few pieces of vital information you should take away from your trade setups when backtesting, these include but are not limited to:

  • Time and Date the Setup was taken 
  • Timeframe of Setup
  • Type of Setup within Trading System
  • Which Market you’re Trading
  • Size of Position 
  • Direction of Trade
  • Price Entered and Exited (also Scaled in/out)
  • Stop Loss price and Size
  • Profit and Loss (in Pips and Currency Value) 
  • Setup Risk per Position (Risk to Reward Ratio of Position)

All of this information will help you when looking back and reviewing your Backtested Setups and choosing which are High Quality, and those to look out for in the live markets. 

Conclusion 

So, here’s what we’ve been through in this blog post: 

  • Why its essential to have a trading plan and idea of how your system works before backtesting it
  • How to test it on TradingView, MetaTrader 4 and automated software traders
  • Why you should Backtest
  • How you should Journal your Backtested Trades

Now all that’s left for you to do is go ahead and start to Backtest your trading system!