What Is Backtesting?
Backtesting is testing a trading strategy against historical market data to evaluate how it would have performed. You define entry rules, exit rules, and position sizing, then run the strategy through years of past data. The resulting metrics (win rate, profit factor, max drawdown, Sharpe Ratio) provide a baseline expectation for the strategy's viability.
How Backtesting Works
Effective backtesting requires: sufficient data (at least 2-3 years, including different market regimes), realistic assumptions (accounting for slippage, fees, and fill probability), out-of-sample testing (testing on data the strategy wasn't optimized on), and walk-forward analysis (progressive testing that simulates real-time decision-making). Overfitting — tuning parameters to perfection on historical data — is the biggest trap.
Why It Matters for Traders
Backtesting is a necessary but insufficient condition for a viable strategy. A strategy that fails in backtesting will almost certainly fail live. But a strategy that succeeds in backtesting might still fail live due to overfitting, changing market conditions, or execution challenges. The backtest provides the hypothesis; paper trading and small live trading provide the proof.
