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

Here’s the scoop straight from the SEC on market orders. 

Extra Insight:

Backtesting with end-of-day data differs from live trading with respect to market orders.   No way can an order in backtesting move the market — it is assumed to execute at the historical price.  One way to account for this discrepency is to specify a slippage assumption that the backtesting engine applies to each trade.

Another approach is to reduce slippage by trading in liquid markets — I look for a volume of 500,000 shares to trade.

A small private trader is unlikely to move a large liquid market.   By sticking to high volume stocks, its not only possible to backtest market orders, its also possible to understand more about the differences between market orders and limit orders via backtesting.

Updated: 11/13/08.

Tags: backtesting, data, market order, slippage, trading

When using a market order, the price is not agreed in advance. An order, even a small one but especially large ones, might move the market and be executed at a surprising price!   The difference between the price quote and the price paid is known as Slippage in the stock trading world and skid among commodity traders.  Most backtesting engines allow the user to make an assumption of how much slippage effects each trade.

Extra Insight:

For my backtesting, I assumed zero slippage.  This is not realistic for market orders but is realistic for limit orders.

Using limit orders in live trading is one way to reduce the cost of slippage.    Trading less frequently is another.

(Backtesting Blog is an Amazon Associate.)

Updated 11/13/08.

Tags: backtesting, limit order, market order, skid, slippage, trading