How to backtest a trading strategy
The most expensive and fool hardy thing you can do is to start trading with real money before you have proven to yourself the validity of your trading strategy in ALL possible market environments.
If your trading ideas have been developed and tested over only a couple of weeks or months, they may or may not work in future market environments! Let me tell you what it takes to make sure your trading strategy is not just another way of gambling away your hard earned money.
In a previous article How to design a successful trading strategy we outlined the four elements of a complete trading system. In this article we are working on the assumption that you have incorporated the four elements above into what you believe is potentially a workable trading system capable of making money.
Why do you need to backtest your trading strategy?
It seems pretty obvious, but let’s spell it out here: Back testing a trading strategy serves two purposes:
You need to be sure that your trading strategy is robust enough to survive and profit in different market environments. You may have developed it in a rising market, but what if the market falls or moves sideways? Will your strategy still work?
Another great advantage is that backtesting your trading methodology will help you to build up experience using your new strategy before using it with real money. It will help you to make your trading decisions more automatic and to not let your emotions get in the way of your trading.
The limits of manual or real-time testing
You could try to test your strategy in real-time by paper trading live, but the boredom and time associated with getting meaningful results will drain your enthusiasm quickly and set a limit to how thoroughly you can test. As a result traders tend to use specialised software to increase the efficiency and accuracy of their testing.
Choosing your backtesting software
When you choose software to help you backtest your trading strategy, make sure it offers everything you need in one place:
- You need as much historical price data as possible from a wide range of asset classes.
- If your strategy involves options to leverage your position you additionally need options data for every strike price and every series/chain over as long a historical period as possible.
- If your strategy uses volatility for triggering or trade-finding, you will also require historical and implied volatility charts for each asset.
- The software should be flexible enough to let you choose any historical date you like and to forward-trade from that date as if for real.
- Even better, how about the application lets you move forward in thirty minute intervals re-engineering the outcome of a trade intra-day.
- You should be able to log your results in theoretical trading accounts, accounting for predetermined slippage and brokerage.
Backtesting with OptionVue
Software applications offering every single feature listed above do exist, and one of them has been the backbone of our research for the past 15 years. That application is the options analysis software called OptionVue. There are probably other testing platforms out there, but few allow backtesting and fewer still have all the data required to test options markets. Please visit our OptionVue overview page to read more about it or to get your free 14 day trial.