In this article, we will explain the backtesting of a trading strategy and how it works, how to backtest a trading strategy inMT4, Zerodha Pi or Sharekhan, and how Excel and Python can be helpful.
What is backtesting?
Suppose you are a beginner in the financial market. In that case, you can ask, “Can I see the potential effectiveness of my trading strategies, whether intraday, option, Forex, or high probability? Is there any algorithm for that?”. The answer is “Yes”.
But what is the best way to backtest the performance of your trading strategies before their implementation in conditions of real markets? It is back testing or estimation based on historical data. The essence of this process is to simulate historical results within the tested trading strategy or investment portfolio.
Why do you need to backtest a trading strategy?
Backtesting is a tool to discover the possible results of your trading strategy. It is based on the idea that a technique that has worked in the past may be effective in the present/future.
Backtest results, whether negative or positive, have an essential meaning in deciding to apply the strategy or not. They allow not only to assess its viability but also to analyze its advantages and disadvantages in detail.
Note! Be careful because tuning the strategy to achieve maximum profitability in the past often leads to the fact that it does not work well in real markets.
How to choose a trading strategy?
There are lots of opportunities to invest and trade in the Indian maeket. If you are in doubt about which strategy to use, visit forums, i.e., Quora, where Indian traders decide what strategy is best for positional trading, discuss crude oil and binary options trading, and the effectiveness of swing and multi-timeframe trading strategies.
It is obvious that you shall find the answer if you want to learn how to backtest your options or any other trading strategies. There are many websites in India to explain backtests. For instance, you may read in Investopedia or download manuals in PDF from Rapidgator and popular torrent sites.
Note! Analysis of a Uni-Directional trading strategy is one of the easiest for beginners. If you are an analyst or portfolio manager, you can read the PDF file that will help in developing and backtesting systematic trading strategies.
Before back-testing your trading strategies, you must decide whether to do this process manually or use the software. The first option is suitable for traders proficient in programming languages, such as Python, and can write the algorithm themselves. Exel will be helpful here; one of the best tools to unload market data.
You can also use paid Bloomberg’s Equity Backtesting Python API software. It offers portfolio managers a ready-made and flexible quantum investment framework for testing existing strategies, analyzing and optimizing portfolios on periodic mainstreams, and exploring new investment hypotheses.
How to manually backtest a trading strategy?
Before relying on automated programs, you can manually backtest your trading strategy. One of the best software programs for this is Excel. The first thing is to upload market data there. After that, you should create an indicator such as RSI or DVI. Then, you need to construct the trading rule. In the end, you should get trading rules/equity curves.
Backtesting trading strategies using Excel could be hard for beginners. However, you may find Excel templates on many wesites. In addition, there are many YouTube videos on how to backtest a trading strategy using Excel by bloggers such as Mark Ursell, Michael Stokes and Jeff Pietch.
Backtesting with Python
Today, Python is one of the most popular programming languages (coding in R and C++ is also widely used). Along with many websites and software programs for backtesting, it can also be applied to analyze the effectiveness of several trading strategies. You can use Python to backtest a Forex or momentum trading strategy.
Top backtesting software
There is a lot of free software available to test the validity of a trading strategy, like Ninja Trader. We recommend also paying attention to paid ones where you can reach more adequate reports, stress tests, and test cases for different trading strategies.
Here are some of the suitable platforms below:
It is a free online trading platform for observing markets. In TradingView, users can efficiently perform manual backtesting and produce info about instruments for Forex trading. You may overview companies’ stocks like CVS, AMP, NEST, AFL, VIEW, SWB:HOT, HPW Metallwerk GmbH, and use a strategy tester in TradingView.
You may backtest any trading mechanics, including algo strategies, in Thinkorswim, a platform to trade stocks, options, etc. It’s suitable for beginners and advanced traders. It doesn’t require a minimum deposit to start and provides a free online trading service.
It is a platform for technical analysis of the stock market like NSE and Forex. The functionality of the program allows you to write and test algorithmic trading systems. In AmiBroker, you may backtest any strategy, including ones for intraday options trading. The platform is equipped with AFL, which stands for AmiBroker formula language. It contains an automatic analyzer, a formula editor, and much more.
Note! You have the option of downloading and using AmiBroker for free, but it is only available for Windows.
It is the largest stock broker in India, with over 120 branches in many states, including Tamil Nadu. More than 9 million clients contribute to over 50% of all the retail trading in India using Zerodha. If you are interested in coding your systems, use https://www.streak.tech, a strategy trading platform from Zerodha that lets you manage your trades online.
Note! Trading on the Pi platform is no longer available, so you cannot apply your strategy in this terminal. The user-friendly Kite platform has replaced Zerodha Pi.
Interpreting and analyzing backtested results
Well, as you are done with backtesting your trading strategies, now it is time to see and analyze the results. There are several key parameters: total net profit, maximal drawdown, total trades, and profit of trades. Thoughtful analysis of these indicators will reveal not only the performance of the strategy but also its risks. If according to the results of the backtest, the maximum allowable loss percentage set by you is exceeded, the strategy needs to be finalized.
Common mistakes in backtesting
When you decide on your strategy and download your data, you may think you are ready for backtesting trading strategies; however, you should be careful about it. There are numerous ways that you can commit errors.
The first standard error is having a faulty data set. Сorrect historical data is crucial to prevent loss and misleading results.
Secondly, the best backtesting trading results are based on numerous trades in testing. You can not expect the correct outcome if you only use one scenario.
Lastly, do not alter the system after testing has begun, as you would lead to a change in the rules of the algorithmic. It is unlikely that you will be able to interpret the results of such a test correctly.
It is important to choose your trading strategies and make sure they are back-tested. Backtesting is also a way of developing your skills as well. You may learn a lot by just analyzing its results.
However, we would like to stress the risks such as misleading data, system errors, etc. Even the most competent backtesting of a trading strategy, whether in Excel or on a proven platform, does not guarantee that it will work in the present/future. Always carefully analyze the current market situation.