Both backtesting and forward testing can and should be used to test a trading strategy. A trading strategy is a set of rules for when to buy and sell an investment, usually in the form of computer code or a trading algorithm.
A trading algorithm can be viewed as a black box that takes in money as input and outputs either the amount of money made from investing according to the trading strategy or the amount of money lost if the strategy is bad. In order to measure how good a system is we need a way to simulate trading with it and thus be able to determine its future profitability given a set of parameters. This is where backtesting and forward testing methods come into play.
In this article, we will find out what backtesting and forward testing are and their benefits.
What is Backtesting
Backtesting is used to check how a trading strategy would have performed in the past.
A backtest simulates the trades that would have been made over some time period using historical data. A trading strategy is considered "backtested" if it uses both buys and sells signals, resulting in an overall increase or decrease of funds over a certain time period.
Backtesting can be performed using open source software or with a paid service depending on how much data you are dealing with. Remember that backtesting is only as good as the quality of your historical data, but it's still important to perform due diligence over the most crucial step in any trading algorithm development process - testing the strategy on historical data.
Backtesting Benefits
Backtesting allows you to check if a strategy would have been profitable in the past. So it can definitely help you avoid a loss by backtesting a strategy with a competitor.
Here are some benefits of backtesting
- Backtesting your algorithm on historical data ensures that it is actually trading within the parameters you choose
- You can get an idea of how many trades will be made and their size. This allows you to calculate the transaction fees which you will incur when using your strategy in real life
- The transaction costs for your entire portfolio can be calculated, something that is almost impossible to do when trading manually
- Your backtesting results will tell you with what certainty the performance of your strategy can be expected in real life
What is Forward Testing
Forward testing is used to test how a trading strategy would have performed if it had actually been in the market.
It's highly recommended that you perform some kind of forward testing on your strategy before deploying real money. If you are serious about using an algorithmic approach to manage your trades then you definitely need to be considering future testing as part of your process.
Forward testing benefits
Performing a forward test on a trading strategy will provide insights into how the strategy may perform going forward.
Here are some benefits of forward testing
- You can plan your trade entries and exits ahead of time
- The strategy would have been tested in a different market condition from the past data used for backtesting
- Your forward testing results will tell you with what certainty the performance of your strategy can be expected in real life
- A mathematical model of the algorithm is created so that it can be simulated before you actually use it in real life
Conclusion
The choice of which to use will depend on the nature of your algorithm. If you are predicting the price of something one day in advance then forward testing is best. However, if you are looking at things over a longer time frame then backtesting may be better.
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