Backtesting

DEFINITION of 'Backtesting'

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. Data Mining

    A process used by companies to turn raw data into useful information. ...
  2. Forecasting

    The use of historic data to determine the direction of future ...
  3. Mechanical Investing

    Buying and selling stocks according to a screen based on predetermined ...
  4. Technical Analysis

    A method of evaluating securities by analyzing statistics generated ...
  5. Autoregressive

    A stochastic process used in statistical calculations in which ...
  6. Neuroeconomics

    Neuroeconomics attempts to connect economics, psychology and ...
Related Articles
  1. Trading Systems & Software

    Backtesting: Interpreting The Past

    We offer some tips on this process that can help refine your current trading strategies.
  2. Active Trading

    Top 10 Rules For Successful Trading

    Whether you're a novice or an expert, these 10 rules should be the backbone of your trading career.
  3. Trading Systems & Software

    Backtesting And Forward Testing: The Importance Of Correlation

    Correlations between backtesting and forward performance testing results can help you optimize your trading system.
  4. Forex Education

    Create Your Own Trading Strategies

    Do-it-yourself trading can be very rewarding - both psychologically and for your wallet.
  5. Forex Education

    Lessons From A Trader's Diary

    Discover what this trader learned from his mistakes and how to uncover your own.
  6. Term

    Three Ways to Profit Using Call Options

    A call option gives an investor the right, but not the obligation, to buy a stock at a specific price, known as the strike price.
  7. Term

    Understanding Rational Choice Theory

    Rational choice theory assumes an individual will always make prudent and logical decisions that yield the most benefits.
  8. Active Trading Fundamentals

    New Traders: Trade the Market in 5 Steps

    New traders shouldn’t throw money at securities without knowing why prices move. Follow these five steps to tilt the odds in your favor.
  9. Investing Basics

    The January Barometer: Is it Still Relevant?

    The January Barometer has been historically accurate. Will that be the case in 2016?
  10. Investing News

    Will China Slip Into a Recession?

    The Chinese economy is an entanglement of many factors gone wrong: an overvalued, engineered stock market, slow GDP growth and a devalued currency. What happens next and what will be the global ...
RELATED FAQS
  1. What is backtesting in Value at Risk (VaR)?

    The value at risk is a statistical risk management technique that monitors and quantifies the risk level associated with ... Read Full Answer >>
  2. What should I look for when choosing a forex trading platform?

    A trading platform is a piece of software that acts as a conduit for information between a trader and a broker. A trading ... Read Full Answer >>
  3. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  4. How does days to cover a short position relate to a short squeeze?

    Days to cover a short position reveals the intensity and duration of a potential short squeeze. A short squeeze occurs when ... Read Full Answer >>
  5. Is it better practice to use a stop order or a limit order?

    Both stop orders and limit orders have their advantages and disadvantages; traders need to decide between the two based on ... Read Full Answer >>
  6. What is the difference between a buy limit and a sell stop order?

    A buy limit order is a specific type of buy order used to enter a market, while a sell-stop order is a sell order that can ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center