Junii Ahmad

Backtesting is the process of applying entry and exit signals to historical price data to quantify, via an equity curve, whether the system would have generated overall profits in the past. A backtest is a lookback at how a quantitative trading system would have performed in the past. While a profitable backtest does not guarantee that the same signals will make money in the future, if they did not work in the past, they are unlikely to work in the future either.
A good backtest increases the likelihood that, since it worked on past data, it will work on future price action, because the signals navigated volatility to generate more profits than losses. The principles of the trading system could be valid, and what allowed for profitability, if that is what the backtest shows.
Trading systems that achieve good risk/reward ratios, with bigger wins than losses, or a high winning percentage with no large losses, will backtest as profitable. Most backtested systems aim to capture market trends and limit losses by avoiding the wrong side of a trend.
A backtest is usually done on a software platform that has historical data and the ability to enter signals, then test how it performed. Some traders do use Excel spreadsheets to backtest their price action systems. For a backtest, input includes entry and exit signals that define when to enter and exit based on price action or technical indicators. Backtests should quantify an entry signal for when to get into a trade. Also, stop-loss and trailing-stop signals for losing and winning trades, respectively, must be part of the input process to keep losses small and maximize gains on winning trades.
Some people will also input profit targets for trades. A stop-loss, compared to a hypothetical profit target, does create a quantified risk/reward ratio. A risk/reward ratio, along with a sufficiently high win rate, can create a profitable system, provided losses are kept small and position sizing is managed properly based on volatility and open risk.
A backtest of signals should be performed on a watchlist of stocks, ETFs, currencies, or commodities you plan to trade. Markets have different levels of volatility and trends, and each should be backtested to assess the validity of signals on historical data.
All a backtest attempts to do is use repeatable, mechanical signals that produce profitable entry and exit dynamics to create bigger wins and smaller losses over the long term. The primary driver of a profitable backtest is cutting losses short and letting winners run. A system needs signals that filter out much of the price-action noise that causes overtrading and instead signal opportunities to capture trends and price swings.
Trading quantified, mechanically backtested signals also filters out much of the emotion involved in deciding what to do each day based on your own opinions and predictions. You change from an opinionated predictor to a follower of a systematic process. Your job becomes following signals and ignoring your own feelings when you quantify your process.
There is no perfect backtested system; there is just the system you can confirm worked across multiple markets in the past and has strong potential to work in the present and future. It has to be a process you can follow with discipline over the long term.
“The moral is simple: Don’t draw any conclusions about a system (or indicator) on the basis of isolated examples. The only way you can determine if a system has any value is by testing it (without the benefit of hindsight) over an extended time period for a broad range of markets.” @Junii Ahmad
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