Backtesting Definition

Backtesting is the process of checking a trading strategy by applying the strategy to historical price data to generate hypothetical trades, then analyzing the results to assess the performance of the trading strategy.

The backtesting engine is the most glorified piece of the operation however it would not be successful without clean data, objective trading strateiges, statiscally sound analysis, and someone to do perform all the tests.

Although most traders concur that backtesting is useful, many traders don’t do it because of the time, expense, and expertise required.    

Backtesting provides a model of trading.   Significant differences with live trading exist such as: commissions, slippage or skid, after hours trading, dirty data, software bugs, human error.  Backtesting results don’t guarantee future performance.    

Backtesting is a screening tool that is really good at eliminating under-performing trading strategies.   If a trading strategy didn’t perform well in the past, it’s unlikely to make money in the future.     

If a set of rules does perform well in backtesting – that’s great but not the end of the game.  Traders ultimately must decide if a given strategy is suitable for their own use.

Last updated 11/11/08.

Tags: backtesting, data, skid, slippage, trading