Article by ForexTime

Back testing a trading strategy is a methodology used in determining if the trading strategy generates profits over a specific period of time.  The process evaluates the profitability of a trading strategy based on historical data.  Many portfolio managers use back testing to prove a strategy they have created works, but fail to evaluate a number of issues that are inherent in evaluating historical returns.  Back testing can be a way to develop a successful trading strategy but there are a number of pitfalls which include:  fitting a curve, slippage, and commissions.

Back Testing Considerations

One of the key assumptions when evaluating a specific trading strategy is determining if the strategy will work in the future.  A strategy that has too many criteria can work when evaluating historical data, but will fail to work when the trading environment changes.  For example, a strategy that works when a market is consolidating might fail if the market begins to trend.  Criteria that is fit to a specific period (known as fitting the curve), will likely have a difficult time producing robust results when forward tested on live data.

Fitting the curve is a process of refining the criteria that is used to create a trading strategy and limiting the time horizon used to back test the strategy.  For example, is an analyst only used 2 years of data on the S&P 500  index to create a strategy and had 10 specific criteria to initiate a trade, it is likely that the strategy will be a good analysis of what occurred in the past, but not be a good predictor of future price action.  The results of a highly refined back test which likely only produce a few results.  The goal of a back test is to produce a robust number of results that are statistically significant and are likely to occur again in the future.

Commissions

The costs of transacting and clearing stocks, futures, options and commodities are called commissions.  Each broker has a different fee, based on a number of criteria including the volume of trading throughout the year, or the type of product that is traded.  Commissions need to be considered; as they also have an effect on the total profit and loss generated by the back tested trading strategy.  A trading strategy should subtract commissions from its results, as these are the costs of doing business that cannot be eliminated when evaluating a strategy.

Summary

Back testing is analysis that can help an investor determine if a trading strategy has worked in the past.  It is very important for an investor to back test a security over multiple time frames to make sure that the strategy has worked during different trading environments.  Once a strategy shows robust historical results, a trader should forward test the strategy in real time to determine if the strategy can work in the present

Article by ForexTime

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