Backtesting is a method used in trading to assess the viability of a trading strategy or pricing model by discovering how it would have played out using historical data. It allows traders to simulate a trading strategy using historical data to generate results and analyze risk and profitability before risking any actual capital. The goal of backtesting is to determine whether a trading strategy would have made money if it had been used during a past period. If backtesting works, traders and analysts may have the confidence to employ it going forward.

Backtesting can be done either manually or by software. To manually backtest, traders first define the financial asset and sample time frame to be tested. Then, they can start observing and analyzing trades based on the strategy in the time frame selected. A trader can observe price charts and gross and net returns from the recorded trades. On the other hand, software backtesting involves running a simulation on the trading strategy using historical data from stocks, bonds, and other financial instruments. The person facilitating the backtest will assess the returns on the model across several different datasets.

Backtesting is particularly useful for complicated trading strategies, such as those implemented by automated trading systems, which are too arcane to evaluate otherwise. A well-conducted backtest that yields positive results assures traders that the strategy is fundamentally sound and is likely to yield profits when implemented in reality. In contrast, a well-conducted backtest that yields suboptimal results will prompt traders to alter or reject the strategy.

In summary, backtesting is a way of analyzing the potential performance of a trading strategy by applying it to sets of real-world, historical data. It allows traders to test trading strategies without risking money and to compare various trading techniques. Backtesting relies on the assumption that strategies that worked well in the past are likely to work well in the future. However, past performance is not always indicative of future results, so it is important to paper trade a system that has been successfully backtested before going live to be sure the strate...