Merits and Demerits of Back-Testing

Back-testing is a method used to evaluate the potential effectiveness of a trading strategy by applying it to historical market data. It helps traders assess how well a strategy would have performed in the past and provides insights into its potential for future success. However, it’s crucial to remember that past performance does not guarantee future results, and real trading involves costs that need to be factored in for accurate risk management and profit analysis.

How it works:

Let’s conduct back-testing to evaluate a trading strategy that involves shorting when the short-term moving average (MA) drops below the long-term MA, aiming for 1.5 times higher profits. We’ll select a sample period, price data, compute MAs, and execute sell orders when the short-term MA crosses below the long-term MA. The resulting returns will help us decide on the strategy’s viability. Back-testing software varies, but it typically involves inputting historical data, setting strategy parameters such as initial capital and stop-loss levels, and running tests with optimization options.

Merits of Back-testing:

• Back-testing allows us to assess the historical performance of trading strategies and provides valuable insights into potential profitability and risk management.
• It helps identify flaws and weaknesses in trading strategies before risking real capital.
• Back-testing enforces disciplined, rule-based trading, reducing emotional biases in decision-making.
• Traders can fine-tune their strategies by analysing past performance.

Demerits of Back-testing:

• Back-testing can lead to over-optimization, where a strategy works well on historical data but fails in real-time due to data-mining bias.
• Past performance does not guarantee future results, and markets can change, rendering some historical data less relevant, making back-test results potentially misleading.
• Ignorance of the impact of real-world factors like slippage, order execution delays, and market liquidity constraints.

Let’s Understand how to Back Testing:

Example: Moving Average Crossover Strategy 

Let’s use a simple example of a moving average crossover strategy as a basis for back-testing:

Strategy Description: Buy when the short-term moving average (50-day) crosses above the long-term moving average (200-day).

Read: Golden Crossover Trading strategies

Sell when the short-term moving average crosses below the long-term moving average.

Steps:

1. Define the strategy: Moving Average Crossover.
2. Gather historical data for a particular stock or asset.
3. Set parameters: Initial capital, position sizing, and moving average periods.
4. Implement the strategy: Write code to execute the buy/sell signals based on the moving average crossovers.
5. Simulate trading: Go through historical data, tracking buy/sell signals and calculating the account balance.
6. Track performance: Keep records of trades, account balance, and key metrics.
7. Evaluate results: Analyse the strategy’s performance metrics, such as profit, drawdown, and the number of winning vs. losing trades.
8. Refine and optimize: Adjust moving average periods, risk management rules, or other parameters to improve performance.

Loopholes in Back-testing:

Back-testing trading strategies is an essential step in assessing their viability, but it’s important to be aware of the potential loopholes and limitations that can arise in this process. One significant loophole is over-optimization, where traders unintentionally fine-tune their strategies to fit historical data perfectly. While achieving outstanding results in back-tests, these strategies may not perform as well in live markets because they have been tailored too closely to past conditions. To mitigate this loophole, it’s crucial to use out-of-sample data for validation, employ realistic assumptions, and avoid overfitting by keeping parameter adjustments conservative.

Another loophole to watch out for is survivorship bias. Back-tests often rely on historical data from assets and instruments that may no longer exist or have changed significantly. This can lead to an overestimation of a strategy’s potential profitability because it doesn’t account for the assets that have failed or disappeared. Traders should use data that reflects real market conditions and consider the impact of delisted stocks or obsolete instruments to ensure a more accurate assessment of their strategy’s performance. Additionally, it’s vital to acknowledge that market conditions evolve over time, and past performance does not guarantee future success, making it essential to adapt strategies to changing environments and stay cautious of the potential pitfalls inherent in back-testing.