A backtest is a process that uses historical data to test the performance of a trading or investment idea. Traders and investors rely on them to test strategies before trading in live market conditions. Backtests are especially useful because market participants always want to be confident in their trading systems or allocation methods before risking any real capital.
A History of Backtesting
Backtests were first mentioned in academic literature in the 1960s. The practice finds its philosophical origins in the idea that by hypothesis testing trading and investment ideas in simulated environments, a trader can better evaluate the quality of his strategies.
It wasn't until the 1990s when the spread of personal computers made backtesting software more available that the practice started to become popular among retail traders. Nowadays backtesting is becoming increasingly common as the trading community not only has more tools at its disposal with which to perform backtests, but also has come to appreciate the precision that translating strategies into quantitative models brings to a trader's process.
How Backtests Work
A typical backtest takes trading or allocation logic and then tests its profitability by running it against historical asset price data. The goal is to simulate how the strategy would have performed in a real environment.
The trading logic tested in a backtest typically makes a decision to buy or sell an asset based on the value of technical indicators, fundamentals, or even alternative data. For example, a trader may want to test whether buying the Invesco QQQ Trust Series each time its price crosses above its 50-day moving average and then selling when it closes below its 200-day moving average is a sound trading strategy. A backtest can provide clues as to whether the strategy is likely to be profitable.
Who Uses Backtests?
In the financial world, investment professionals backtest individual trade ideas and entire portfolios, to assess opportunity and risk as well. Financial advisors often employ backtesting to help their clients imagine outcomes that their investment decisions may have on their retirement portfolios. And portfolio managers managing institutional-sized assets utilize backtests to evaluate how adding a new position may change the return of a fund.
For banks, risk modeling is a common backtesting application. They commonly use backtesting to estimate how much volatility they can tolerate in their portfolio, and whether they will need assistance from the federal reserve during periods of stress and reduced liquidity.
Individual traders, on the other hand, tend to use backtests to evaluate individual trade ideas or algorithms. And as backtesting tools become increasingly accessible to retail traders, we continue to see more and more individuals outside the trading and investment professions utilize them in their trading and investment process.
Backtesting is especially important for new traders because it can help them determine whether or not a trading strategy or investment idea has merit before they actually put their money on the line. Regardless of your trading experience, you can practice backtesting by signing up for Tradewell. The free version of the platform provides curious traders with over 9,000 metrics and 90,000 assets which they can backtest across 7 years of market data.