How to Effectively Back Test a Trading Strategy

Traders are always searching for superior portfolio-enhancing strategies. Day traders and investors exert a great deal of effort in this pursuit, and their success is frequently contingent on their research abilities and more importantly, their risk tolerance. When a portfolio manager or trader has the capacity for greater risks, he or she is typically rewarded with greater portfolio returns. However, the most essential factor for any speculator is to test the results of their strategy prior to incorporating it into their portfolio. Here are some important factors that traders should consider.

Background

When formulating a thesis for an investment or trading strategy, the majority of traders primarily employ fundamental or technical analysis. A fundamental trader will typically consider the macroeconomic environment of the country, the global economy, and the industry in which he or she invests. This year, for instance, the Fed has been engaged in a battle against inflation, and in order to succeed, they have been increasing interest rates. The Fed's hawkish monetary policy posture has weakened economic activity, but the stock market has actually gained ground. In context, the Nasdaq index has gained roughly 29% so far this year. If one had paid close heed to the prognosis for the earnings seasons or economic data, one would not have anticipated this result for the Nasdaq index from a fundamental perspective.

On the other hand, a technical trader could care less about the underlying fundamentals; they focus solely on the price. What matters to them are price charts and everything else. A technical trader will employ a technical study and, based on the results of this analysis, implement a trend-following portfolio strategy.

Common Mistakes

It is crucial, in my opinion, not to disregard any common type of analysis or to rely solely on a single type of analysis. A trader must have a thorough comprehension of the economy and the industry in which he or she intends to invest. By comprehending the fundamentals of the economy, sector, or stock, you increase your chances of success. Returning to the example of the U.S. economy, the Nasdaq index is extremely sensitive to the inflation rate. In addition, the entire equity market is sensitive to the Federal Reserve's monetary policy. If inflation continues to decline under current conditions, there is a greater chance that the Fed will have little to no reason to raise interest rates further. This indicates that the Federal Reserve is likely to adopt a dovish to neutral monetary policy, which should benefit the equity market.

A trader who wishes to place a trade on the Nasdaq index based on simple technical analysis will gain an advantage if they pay close attention to the economic numbers like inflation data, as the trajectory of the Fed's monetary policy and the stock market will be heavily influenced by inflation data.

Past Performance And Over Fitting

• On the technical side, speculators must realize that past performance is no guarantee of future results. Before implementing a strategy in the actual portfolio, a trader must first conduct a comprehensive back test. In addition, when back testing a strategy, a trader must be aware of the folly of overfitting a strategy by optimizing the results of the back test. This is due to the fact that your computer is guaranteed to discover a combination of moving average that would have yielded excellent results, but the reality is that you are supplying it historical data of prior trends that are unlikely to repeat precisely.

In order to overcome this particular aspect of back testing, a trader must pay close attention to a number of the following factors:

• Maximum drawdown ratio
• Profit factor
• Sortino ratio
• Sharpe ratio

A trader must not search for an out-of-the-ordinary timeframe or moving average, as most systems would not permit them to do so. There are a variety of back testing programs that can assist you in optimizing your strategy based on a time frame; however, I consider them to be more of an example of overfitting: something that will only give you good results in the past, whereas in reality it will not generate results that are close enough to previous numbers. 

An Effective Method To Back Test A Strategy

Examine the overall trend of the asset class and determine if this trend is more likely to persist or if it will change based on your analysis of the underlying fundamentals. If the market has been trending higher and fundamentals indicate that the market is more likely to move higher (for example, due to the Fed's monetary policy), then examine the back test period of that derivative when the underlying asset class was trading in the same direction.

Additionally, give close attention to the overall profit and loss curve and ensure that it is as seamless as possible, with no significant drawdowns or astronomical profits on any single trade. If the market is anticipated to move in a sideways or downward trajectory, the same procedure must be followed.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Stocks