Backtesting Algorithmic Trading

Thinking about using computers to trade stocks? It sounds smart, right? But jumping straight into using these "algo" trading systems with your real money can be risky. Imagine driving a race car without ever practicing!

That's why backtesting is super important. Think of it as a test drive for your trading ideas. It lets you see how well your computer trading strategy would have worked in the past, before you risk any actual money.

What is Backtesting?

Imagine your computer trading strategy as a set of rules. Backtesting is like playing a video game where you test those rules on old market data.

You give your strategy to a special program. This program uses past stock prices and market info. Then, it pretends to trade as if it were actually in the market back then.

The program follows your trading rules and sees how much money you would have made or lost. It’s like a practice run, but with market history.

Why is Backtesting So Important?

Backtesting isn't just a fancy extra – it's a must-do if you're serious about algo trading. Here's why:

• Spot Problems Before They Cost You: Backtesting can show you if your trading idea has hidden flaws or if it's just not going to work well. Finding problems in testing is much cheaper than losing real money in the market!
• Make Your Strategy Better: After a backtest, you'll see what worked and what didn't. You can then tweak your rules to try and improve your strategy. It's like fine-tuning an engine to make it run smoother and faster.
• Get Confidence (But Be Realistic): If your strategy does well in backtesting, it can give you more confidence to use it for real. But remember, past success isn't a guarantee of future profits.
• Compare Different Ideas: If you have a few trading ideas, backtesting lets you compare them side-by-side. You can see which one seems to work best based on past performance.
• Adjust Settings (Carefully): Backtesting can help you find the best settings for your strategy, like how often to trade or when to buy and sell. But be careful not to make it too perfect for the past (more on that later!).

How Does Backtesting Work? Step-by-Step

Here's a simple breakdown of how backtesting usually works:

1. Write Down Your Trading Rules: First, you need to clearly write down all the rules of your trading strategy. When do you buy? When do you sell? How much do you trade? Be very specific.
   
2. Get Past Market Data: You need good, accurate data from the past. This data should include prices for the stocks or assets you want to trade, going back for a while (years if possible).
   
3. Use a Backtesting Tool: There are many programs and websites you can use for backtesting. Some are free, and some cost money. Choose one that fits your needs. (Some popular apps mentioned earlier like Streak and Sensibull have backtesting features).
   
4. Put Your Strategy into the Tool: Tell the backtesting tool your trading rules. This might involve writing code or using a simple visual interface, depending on the tool.
   
5. Run the Test! Start the backtest. The tool will simulate trading based on your rules and the past market data.
   
6. Look at the Results: After the test, you'll get reports showing how your strategy performed. Look at things like:

• Total Profit/Loss: Did you make money overall?
• Biggest Loss (Drawdown): How much did your account drop at its worst point? This shows risk.
• How Often You Won (Win Rate): Percentage of trades that made money.
• Profit vs. Loss Ratio: Are your winning trades bigger than your losing trades?

Change and Test Again (If Needed): If the results aren't great, go back and change your strategy rules. Then, backtest again to see if it's better. This is how you improve your trading idea.

Important Warnings About Backtesting

Backtesting is great, but it's not perfect. Here are some things to keep in mind:

• Past Performance is Not a Guarantee: Just because a strategy worked well in the past doesn't mean it will work in the future. Markets change.
• Don't Make it Too Perfect for the Past: It's tempting to tweak your strategy until it looks amazing on past data. But if you make it too perfect, it might only work for that specific past data and fail in the real world. This is called "overfitting." Aim for a strategy that works reasonably well, not perfectly.
• Data Must Be Good: If your past market data is wrong or incomplete, your backtest results will be wrong too. Use reliable data sources.
• Costs Matter: Backtests often ignore trading costs like fees and slippage (getting a slightly worse price when you actually trade). In real trading, these costs can reduce your profits. Try to factor in realistic costs if you can.
• Markets Change: Markets aren't static. What worked well in the past might not work now because market conditions have shifted. Backtest over different time periods to get a better picture.
• Unexpected Events Happen: Backtests can't predict surprise events like big news shocks or crashes. Always have a plan to manage risk, no matter how good your backtest looks.

Key Numbers to Watch in Backtesting

When you look at backtest results, focus on more than just profit. Here are some important numbers to pay attention to:

Conclusion

Explore Ready-Made, Backtested Strategies with Stratzy

Backtesting is your vital first step into algo trading. It's like practicing before a big game or rehearsing before a play. It helps you find problems, improve your strategy, and gain confidence before you risk your hard-earned money in the live market. By rigorously testing your ideas with historical data, you move from guesswork to a more informed and data-driven approach to algorithmic trading.

But building, coding, and meticulously backtesting strategies from scratch can be time-consuming and complex. If you're looking for a shortcut to get started with the benefits of backtested algorithms, consider exploring platforms like Stratzy. It offers a compelling option by providing ready-made, professionally designed, algo strategies that are already backtested and vetted.