Backtesting

What is 'Backtesting'

Backtesting is the process of testing a trading strategy on prior time periods. Instead of applying a strategy for the time period forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data in order to gauge the its effectiveness.

Most technical-analysis strategies are tested with this approach.

BREAKING DOWN 'Backtesting'

When you backtest a theory, the results achieved are highly dependent on the movements of the tested period. Backtesting a theory assumes that what happens in the past will happen in the future, and this assumption can cause potential risks for the strategy.

For example, say you want to test a strategy based on the notion that Internet IPOs outperform the overall market. If you were to test this strategy during the dotcom boom years in the late 90s, the strategy would outperform the market significantly. However, trying the same strategy after the bubble burst would result in dismal returns. As you'll frequently hear: "past performance does not necessarily guarantee future returns".

RELATED TERMS
  1. Optimization

    In the context of technical analysis, it is the process of adjusting ...
  2. Look-Ahead Bias

    Bias created by the use of information or data in a study or ...
  3. Universe Of Securities

    A set of securities that shares a common feature such as the ...
  4. Mechanical Investing

    Buying and selling stocks according to a screen based on predetermined ...
  5. Time-Period Basis

    An implication surrounding the use of time-series data in which ...
  6. Cash Neutral

    An investment strategy strategy that requires no net cash in ...
Related Articles
  1. Trading

    Create Your Own Trading Strategies

    Do-it-yourself trading can be very rewarding - both psychologically and for your wallet.
  2. Trading

    How To Start Trading: Testing Your Trading Plan

    An important part of a trading plan is testing to determine what you can expect of its performance. Backtesting and forward performance testing will help you predict if your plan will succeed ...
  3. Managing Wealth

    Using Technical Indicators To Develop Trading Strategies

    Unfortunately, there is no perfect investment strategy that will guarantee success, but you can find the indicators and strategies that will work best for your position.
  4. Trading

    Backtesting And Forward Testing: The Importance Of Correlation

    Correlations between backtesting and forward performance testing results can help you optimize your trading system.
  5. Trading

    Manipulating Facts to Fit a Theory: A Dangerous Trading Practice

    This practice is common with experienced and new traders, and it can lead to huge losses. Find out how to avoid it.
  6. Investing

    Stimulate Your Skills With Simulated Trading

    Think you can beat the Street? We'll show you how to test your abilities without losing your shirt.
  7. Trading

    No Forex Strategy Of Your Own? Try Mirror Trading

    There are many advantages to trading a mirror strategy, yet markets are dynamic, and regardless there is always a risk of losses.
  8. ETFs & Mutual Funds

    Are All Smart Beta Strategies Really Smart? (PKW, SPYB)

    Explore the methodologies used by smart beta funds and the reasons their strategies for stock selection may not be all that smart.
  9. ETFs & Mutual Funds

    How Smart Beta Offers No Due Diligence for Investors

    Explore the challenges presented by smart beta funds regarding due diligence, including proprietary methods for stock selection and active management practices.
  10. Trading

    4 Steps To Creating A Better Investment Strategy

    Make your trading safer and more streamlined by following these simple guidelines.
RELATED FAQS
  1. What is backtesting in Value at Risk (VaR)?

    Learn about the value at risk of a portfolio and how backtesting is used to measure the accuracy of value at risk calculations. Read Answer >>
  2. Where do investors tend to put their money in a bear market?

  3. What are common trading strategies when identifying a double top

    Learn strategies traders use when a double top pattern is spotted. This pattern is common and can be profitable in the equity ... Read Answer >>
  4. What is your opinion on the 50/200 moving average strategy?

    A co-worker recently mentioned the 50/200 moving average strategy. I went online and discovered that this system seemed to ... Read Answer >>
  5. What is stress testing in Value at Risk (VaR)?

    Discover the difference between Value at Risk, or VaR, and stress testing, and learn how the two concepts might be used together ... Read Answer >>
  6. What lessons did the tech bubble crash give to investors in the Internet sector?

    Learn how investors contributed to the dot-com bust and how Internet services and investing has changed since the market ... Read Answer >>
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center