Traders who are eager to try a trading idea in a live market often make the mistake of relying entirely on backtesting results to determine whether the system will be profitable. While backtesting can provide traders with valuable information, it is often misleading, and it is only one part of the evaluation process.
Backtesting refers to applying a trading system to historical data to verify how a system would have performed during the specified time period. Many of today’s trading platforms support backtesting. Traders can test ideas with a few keystrokes and gain insight into the effectiveness of an idea without risking funds in a trading account. Backtesting can evaluate simple ideas, such as how a moving average crossover would perform on historical data, or more complex systems with a variety of inputs and triggers.
Many trading platforms also allow for optimization studies. This entails entering a range for the specified input and letting the computer “do the math” to figure out what input would have performed the best. A multi-variable optimization can do the math for two or more variables to determine what combinations would have achieved the best outcome. For example, traders can tell the program which inputs they would like to add into their strategy; these would then be optimized to their ideal weights given the tested historical data.