Different ways of backtesting a trading strategy automatically
This is where backtesting a strategy using software helps. You can get an idea if the principles of the strategy hold up over a longer term much more quickly. You can do this in two ways: using backtesting software or using a robot.
Using backtesting software
You can use special backtesting software, such as FOREX TESTER, that allows you to test a strategy over a longer period of time, using real historical data. This type of software allows you to rewind the historical market data and trade through a number of days, weeks or months by speeding up the time.
To find out more on how to acquire this software, you can go to the following:
Using a robot
An alternative to using backtesting software is to use a robot or an Expert Advisor. The robot would go through the historical data at a fast pace and mimic the trades that you could have taken using the strategy, allowing you to see what your results would have been like.
Considerations to bear in mind
Whether you use backtesting software, such as FOREX TESTER, or you use a robot to test historical data, you must bear in mind that past performance is not indicative of future results.
When you are testing a strategy, you should not be trying to see how much percentage increase you can make on your account or how much money you could make. The simple fact is that you will never know what the markets will do and so from one month to the next you will not know what kind of performance you can achieve.
When you are backtesting a strategy, you are seeing if the principles of the strategy will work with certain assets or in certain market conditions.
If, for example, you are looking to test a strategy that captures part of a trend and successfully filters out trades in a ranging market, then by testing the strategy using software, it will allow you to see if the strategy actually manages to achieve this.
If the results turn out to be unprofitable, then you may want to consider ways to filter out unprofitable trades and reduce losses. If the results turn out to be profitable, then you may have a strategy that you can work with in a live market environment.
Avoid curve fitting
However you must bear in mind that you should never tweak your strategy to the point where you achieve maximum profitability. This is known as curve fitting and means that you have optimised your strategy to achieve the maximum performance possible based on what has happened in the past.
Past performance is not indicative of future results
This will not help you in the future, because the conditions in the past that gave you a substantial performance on your over-optimised strategy will change, even if slightly, and you will not achieve the same results.
You need to stick to making sure that the principles of the strategy work and look to optimise your strategy in a live environment based on current market conditions, not past market conditions.
Backtesting is not exact
You should also be aware that there are other practical factors that can affect you results. First of all, different brokers have different price feeds and spreads. Using different brokers to test a strategy may produce different results.
Practical application will be different to backtesting results
There is also a difference between practicing a trading strategy and applying it in a real environment. In a live environment you are more likely to succumb to emotional influences. You are also likely to make mistakes or react more slowly when you are actually trading a strategy. You should be cautious as you will most likely not be able to execute trades as consistently as a robot does, or as well as you do in a practice environment.
Large position sizes can can change results
When you have a small starting capital, you are limited in the amount of volume that you can trade. As your account size grows, you can trade with more volume and increase your risk to get larger returns.
However, when your account becomes very large, this can produce a unique set of problems. For a start, in certain markets where the liquidity is very thin, you can actually move the price of the asset simply by placing your order.
This may give you slower execution speeds or you may not be able to get the exact price that you want. Using backtesting software over historical data will not take these factors into account, whereas in a live environment, they will be inherently present.
Backtesting is a means of deciding whether a strategy is worth pursuing or not
On the whole, backtesting using software can be very useful. Although it cannot generate a concrete conclusion as to how much you can increase your account by, or how much you can make in the future, it can give you a good basis as to whether your strategy will work or not.
By testing your strategy out over a longer period of time, you get a larger sample size and this makes the testing environment more accurate, leaving you to feel confident that the underlying principles that you built a strategy on, hold up over a longer period of time.
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