11 May, 2020, | AtoZ Markets- In 1980, backtesting was a pretty straightforward concept. Traders would make their trades on charts, to know the position either to 'buy' or 'sell'. Therefore, they would manually write notes of their trading results. Most of the trading ideas came from the understanding of fundamental analysis. Later on, in the 1990s, people were able to display data on a computer monitor.
The electronic process allows traders to check results online and identify the effectiveness of strategies. Moreover, technological advancements have simplified the process for us.
The stock market is very sensitive to the economy and human psychology. Therefore, the market changes with the introduction of new technology, innovation, trading strategy, human behavior, and technical analysis. In this situation, implementing a trading strategy is much complex than in the 1980s. However, to remain successful in the industry you must have a trading strategy that can guarantee you a maximum benefit with minimum risk, and backtesting is a way to find it. There is a lot of backtesting software available on the internet and you need to find the right one for you.
In the following section, we will see the process regarding how to backtest stock trading strategies with a step by step approach.
Let's start with what the backtesting is.
What is Backtesting?
Stock backtesting is a process to construct one or more portfolios on different stocks to analyze and observe the overall performance of the stock. It is taken into account to be a vital tool for a trader's toolbox, without which they wouldn't even consider diving into the markets. Stock backtesting is important like market observation before purchasing anything. If you want to buy a car or mobile phone you'd want to see the history of the brand, its features, etc. A similar theory applies to stock strategy.
Backtesting is the process of testing a financial trading strategy on prior periods. Rather than applying a technique for the period forward, which could take years, a trader can simulate a trading strategy based on relevant past data.
For example, some trading strategies work well in the volatile market condition and some work well in non-volatile trends. There are a few trading strategies that can give you profit from all market conditions. In order to find the ultimate trading strategy, you need to test it on all market condition and backtesting makes the thing easy for you.
Let's move to the core part of backtesting stock strategies. Remember that before implementing the backtesting you need to take some precautions as mentioned below:
As a retail trader, you should follow these steps to identify and support a trading strategy:
- Identify a trading strategy that suits your personality.
- Find some stocks to check with a structured backtest.
- Identify changes and improvement and process the final backtesting.
Implement Backtest Stock Strategies
If your trading strategy can pass through these steps, you can use it for living. All you need to do is follow the trading system accordingly with appropriate money management skills.
Let's move to the process of backtesting stock strategies with a step by step approach-
Identifying the Strategy
The trading strategy is systems of buying and selling stocks depending on several indications of the market. There are thousands of trading strategies available in the world. All you need to do is to find one that suits your personality. If you are available to trade full time, you can choose the scalp while for part-time traders, you can go for swing trading.
In the following section, we will use a trading strategy based on Stochastic RSI. However, you can follow the trading strategy that suits you most.
The strategy that we are going to see is straightforward and easy to follow for all traders:
- Enter a long trade for signals generated by the system, unless the Stochastic RSI is around 80. The RSI indicator is free and available in all trading platforms like MT4, Tradingview, MT5, or cTrader.
- Exit the trade when the RSI moves above 80, and moving average 20 crosses the moving average 50.
- Moreover, you can add other conditions to decrease the frequency of the signal and increase the probability.
- The risk vs reward of any money management depends on the traders' personality. Therefore, we are not going to discuss this here.
Find Stocks to Backtest
In this section, you can use stocks that have good liquidity, and that is available to trade in most of the platforms. For example, you can use Microsoft stocks or McDonald's along with a bunch of currencies. You can follow these tips while selecting currencies:
- Testing currencies across sectors is suitable rather than stocks as most of the tech stocks during the years saw a bottom.
- Test at least two or more highly uncorrelated currencies or stocks to see how the strategy works in different data sets.
Here is some example of uncorrelated stocks:-
- DUK (Energy)
- AIG (Financial — Property / Casualty Insurance)
- GILD (Biotechnology)
- GS (Financial — Investments)
- JNJ (Healthcare)
- KO (Consumer Goods — Beverages)
- MSFT (Technology — Business Software)
- WMT (Services — Discount Variety)
Running the Backtest
In this section, you need to apply your trading strategy with the help of trading simulator software. There are many backtesting software available on the internet, where you need to choose one from them.
In this section, we will use TradingSim, a trading simulator where you can practice trading strategies using a simulated account. With this software, you can open and close positions on stocks utilizing a demo account, and it will work as if they were real stocks. However, the only drawback is that you can backtest only two years.
In the image above, you can see a backtest for a stock with a full two years with a demo $10,000 account. For each trade, there is almost 20% of capital taken as a risk, and the results were promising. Over two years, each stock made a healthy return.
Further About Backtesting
We have seen a complete way to backtest stock strategies. However, this might not satisfy you; therefore, you can use more simulating software like Tradingview or MetaTrader.
Backtest Stock Strategies through Tradingview
It was launched in 2011. It is a good option for stock and forex backtesting software and famous for its advanced charting tools. The real-time data and browser-based price charts make you possible to research from anywhere.
To use it for backtesting stock strategies, following these steps:
- Turn on Bar Replay by using the icon on the toolbar at the top of the trading screen.
- After activating the chart, a new toolbar will appear, and a vertical red line will appear on the cursor. The replay will begin from the red line area. You can scroll back to the point where you want to start.
- Click on the chart to get into replay mode. Therefore, click on the play button so the replay can start.
- The playback feature is a fantastic tool to understand what the charts looked like on a specific day.
However, there are certain limitations of TradingView that you should know:
- There is no option to use Japanese Candlestick Charts.
- The 'Continuous Futures' chart doesn't work with 'Bar Replay'
- You cannot create demo orders.
Backtest Stock Strategies through MT4
After downloading the MT4, you should open the main menu and navigate the "View" section where you can find the "Strategy Tester". On the other hand, you can just press "CTRL+R" and press the 'tester' button.
Some of the key features of the Strategy Tester in MT4 are described below:
- It is one very popular trading simulator that combines the charting tools of MT4 with tick-by-tick data. You can use it as an ideal backtesting trading strategies on the platform.
- Offline charts are available with indicators, templates, and several drawing tools.
- You can download tick data from external sources. You can access nearly ten years of real tick data.
- This strategy tester is available free to use on MT4, and you can use it as a free Forex trading simulator app.
- You can open multiple charts at a time.
- You can import important news releases through the economic calendar.
- This software allows access to all in-built and custom indicators.
- You can save simulation data to a file to access later on.
- You can continue simulation on stocks and stock indices too.
Traders who apply computing power and leave human logic are likely to suffer huge losses. When it comes to backtesting stock strategies, no software can replace human trading psychology with the right tools.
Therefore, besides backtesting, there is more to do with human logic. Moreover, risk vs reward and money management is a vital part of every strategy that distinguishes between successful and unsuccessful traders.
Think we have missed something? Let us know in the comment section below!