Backtesting is a technique that helps traders determine the profitability of a strategy. It is also a good way to measure risk and understand the potential of a strategy. However, backtesting is not a reliable predictor of future performance. Traders should not use it alone. They should use it in conjunction with other factors.
Forward performance testing is another method of testing trading strategies. The idea is to document all trades that the system would have executed based on the logic of the system. These records include profits and losses.
For instance, if a trader believes that a trend-following system would do better than a simple moving average strategy, he should backtest the strategy. When it fails, he should alter the strategy.
A good backtest should select sample data from a relevant time period. It should avoid biases such as pre-inclusion and survivorship. Other variables that can affect the results of backtests are order book depth and liquidity.
In the case of trend-following, a trader should avoid data that was delisted or was not available for long periods of time. This could hurt the performance of the strategy.
Another type of backtesting is scenario analysis. It simulates the impact of unfavorable events on a portfolio’s value. This is often used to determine how the worst-case scenario may play out.
A common mistake made by novice traders is using emotional biases to guide their trading decisions. Such decisions are not only misleading, but can also be harmful in the long run.