10 Rules For Backtesting Trading Strategies

Backtesting is an essential practice for traders looking to evaluate and refine their trading strategies. By simulating trades using historical data, traders can gain insights into a strategy's potential performance without risking real money. This process is critical for both novice and experienced traders. Here, we present ten key rules to consider when backtesting trading strategies, ensuring that you maximize the effectiveness of your evaluation.

1. Consider Broad Market Trends

When backtesting a strategy, it's vital to take into account the overall market conditions during the period tested. A strategy that was only backtested from 1999 to 2000 may not perform well in a bear market. It's beneficial to backtest over a long timeframe that includes various market conditions to see how the strategy holds up under different scenarios.

2. Define Your Universe of Stocks

The universe of stocks you choose for backtesting significantly impacts the results. For instance, testing a broad market strategy on a universe consisting solely of tech stocks may not provide reliable insights for other sectors. If your strategy targets specific genres of stocks, limit the universe accordingly. Otherwise, maintain a broad and diverse universe to ensure comprehensive testing.

3. Monitor Volatility Measures

Volatility is a crucial factor, especially for leveraged accounts prone to margin calls. High volatility can increase risk and complicate transitions in and out of positions. Aim to develop strategies that keep volatility low, thereby reducing risk and enhancing the stability of your trading system.

4. Evaluate the Average Number of Bars Held

The average number of bars held is an important statistic to monitor. While many backtesting software programs include commission costs in their calculations, it's still vital to consider this metric. Increasing the average number of bars held can help reduce commission costs and improve overall returns.

5. Manage Exposure

Exposure in trading can be a double-edged sword. Higher exposure can lead to greater profits but also higher losses, while lower exposure reduces both. Keeping exposure below 70% is generally advisable to mitigate risk and facilitate smoother transitions in and out of positions.

6. Optimize Position Sizing with Average Gain/Loss and Wins-to-Losses Ratio

Combining the average-gain/loss statistic with the wins-to-losses ratio can help determine optimal position sizing and money management techniques, such as the Kelly criterion. By increasing average gains and improving the wins-to-losses ratio, traders can take larger positions and reduce commission costs.

7. Benchmark Using Annualized Return

Annualized return is a critical metric for benchmarking a system's performance against other investment options. It's not enough to look at the overall return; consider the risk-adjusted return as well. A strategy should outperform other investments at equal or lesser risk to be viable.

8. Customize Backtesting Parameters

Accurate backtesting requires precise customization of parameters such as commission amounts, lot sizes, tick sizes, margin requirements, interest rates, slippage assumptions, position-sizing rules, stop settings, and more. Fine-tuning these settings to mimic the actual trading environment helps achieve more accurate backtesting results.

9. Avoid Over-Optimization

Over-optimization occurs when a strategy is excessively fine-tuned to historical data, making it less effective in the future. To avoid this, implement rules that apply broadly across different stocks and market conditions. Avoid tweaking rules to the point where they become overly complex or no longer make sense.

10. Validate with Paper Trading

Backtesting alone isn't always sufficient to gauge a strategy's effectiveness. Sometimes, strategies that performed well historically may fail in current market conditions. Therefore, it's crucial to paper trade a successfully backtested system before going live. This step ensures the strategy remains applicable in practice.

Conclusion

Backtesting is a powerful tool for traders to evaluate and refine their strategies. By considering broad market trends, defining a suitable universe of stocks, monitoring volatility, managing exposure, and optimizing position sizing, traders can develop robust and effective trading systems. Customizing backtesting parameters and avoiding over-optimization further enhances the reliability of the results. Finally, validating with paper trading ensures that strategies remain viable in real market conditions. By following these ten rules, traders can make more informed decisions and improve their chances of success in the markets.