Before you buy a phone, laptop, or anything else, you want to make sure it works by testing it out; the same practice should be carried out in commerce. You should not use your trading strategy in the live market without testing whether it works or at least having an idea of the results it can bring, which is why you should backtest it.
What is back testing?
Many new traders go through the cycle of developing a strategy that seems to work, using it for a while, and abandoning it after losing a series of trades. They then look for other strategies and repeat the cycle. As a result, many of them give up trading, believing that no one can consistently be profitable in the crypto market or that crypto trading is not for them.
So instead of going through the cycle of stopping to use one trading strategy and choosing another when you start losing trades, you can test your strategy with data to see how it would look over time gone without risking money. A positive result will help you feel more confident in such a strategy.
Backtesting allows you to assess the potential performance of your crypto trading strategy based on historical data. The idea is that any outcome a strategy produces on historical data is likely to repeat itself. Thus, a strategy that delivers good results by testing it against historical data has a high probability of performing well in future market conditions and vice versa.
4 reasons why you should backtest your trading strategy
Below are some of the benefits of back testing your trading strategy.
1. A risk-free strategy test
You don’t have to risk your trading capital when backtesting your strategy. Instead of testing your trading strategy on a live trading account, backtesting is an ideal solution.
2. Refine your strategy
Backtesting reveals the strengths and weaknesses of your strategy. You can then use the information to tailor the strategy to your trading needs and personality type.
3. More confidence in your trading strategy
Backtesting allows you to try out different market strategies to pick the best one. This practice will increase your confidence in your strategy, especially if it performs well over much of the market data.
4. Get new ideas
Since the backtesting process exposes you to a lot of data, you are likely to see more repetitive trading patterns, making it possible to generate new trading ideas.
Two ways to backtest your strategy
Backtesting your crypto strategy can be done manually or automatically.
To backtest your strategy manually, you need to place trades on the historical data yourself. To perform manual backtesting, you need to perform the following steps.
- After opening an account with a reliable crypto exchange, open the card configuration of your desired asset.
- Backtesting requires a strategy. You also need to decide on the tools and indicators you want to use. For example, your strategy could be to trade trend rebounds (bearish or bullish) on BTCUSD within a one hour time frame after the price bounces off the 61.8% level using the Fibonacci retracement tool. The 61.8% Fibonacci level must also merge with the trendline to validate the move.
- Since you now have a strategy, the next thing to do is scroll back to where you want to start the backtest. In the case of BTCUSD, you can start as early as 2013. You can then search for trends on the hourly chart to see the possibility of a continuation of the trend after a retracement that meets your requirements.
- When you see a relevant setting, use the tools and indicators you want to test on the chart. In this case, the Fibonacci retracement tool and the trendline. Then plot the chart as you would if you were trading the move when it initially happened. Then move your chart from candlestick to candlestick to see the result. The idea is to slowly move the chart forward to see the outcome of the trade and then document the result.
- As you write down the result, you can keep scrolling to get new settings, use your trading tools to analyze them and move on to see what happened. Repeat this process until you’ve gone through a lot of data. Some platforms like TradingView allow you to autoplay and pause the historical data so you don’t have to scroll yourself. You can also control the playback speed on the card. This is available to the Pro, Pro+ and Premium users of the platform.
Manual backtesting can help you get to grips with the bad trading psychology a bit as you will be emotionally involved to some degree. The method also requires no coding skills.
On the other hand, manual backtesting is time consuming as you need to analyze a lot of historical data to get your results. It is also easy to make mistakes when following your previous data or the results. Manual backtesting also gets more tedious if you’re trying to review multiple timeframes.
This backtesting method helps you use technology to test whether your strategy is working, usually using coding to streamline the process. It allows you to test your strategies over a long period of time easily and faster. Based on the generated data, you then know whether your strategy is adequate and what you need to adjust.
Automated backtesting works the same way as manual backtesting. You also need to choose a time frame, your trading assets and the strategy to test. The main difference is that you don’t have to set up every process, write down every order and calculate the profit and loss yourself – they are all done automatically.
The main challenge of automated backtesting is that you may need to know how to code or at least have easy access to coding experts.
Disadvantages of backtesting your strategy
While testing your crypto trading strategy is always helpful, there are some drawbacks.
Past success is no guarantee of future results
Adjusting and refining your strategy based on historical data results can affect its effectiveness. Market conditions are constantly changing. Therefore, a strategy that worked well in the past may not work well in the future. It is also possible that the historical data you use is characterized by many adverse market events, negative and positive sentiments, etc.
For example, market conditions during the 2020 pandemic lockdown may not represent regular market conditions, and the results obtained through such data may not accurately reflect future market conditions.
Crypto market is still new
The crypto market is relatively new and some tokens do not have enough data to test your strategy. For example, consider Shiba Inu; you only have access to charts and data from late 2020, which may not be enough to conclude a particular pattern.
The crypto market is also young and volatile, making it difficult to spot certain patterns, such as in the forex and stock markets. The price of Bitcoin still largely affects the price of many other cryptocurrencies.
3 Important Tips for Cryptography Backtesting
The following tips are helpful when testing your strategy.
1. Don’t Be Selective With Data
Make sure to use random data sets, not just sets that seem to favor your strategy. You should not cheat yourself by using only past data that makes your strategies look good. This exercise will only make you fail when using real-time data.
2. Be thorough
You don’t have to hurry. By being thorough, you can spot any flaws that causal backtesting may have overlooked. Leave no stone untouched. To be thorough, use as much data as possible to see how your strategy works in different market situations.
3. You will never have a perfect strategy
All strategies have their flaws or moments when they experience losing streaks. All you want to make sure is that whatever trading style you use will be profitable in the long run and deliver the desired result. You will also need to adopt some risk management practices to make this happen.
Choose your backtesting style
Backtesting can help your crypto trading strategy when you execute it correctly. To determine the best between manual and automated backtesting, you need to consider several factors such as how much time you have to backtest, your personality, etc.
Manual backtesting can be very time consuming and can also lead to errors. On the other hand, automated backtesting is less cumbersome but requires the technical know-how to create it or access experts who can create the required software. Nevertheless, the two ways of backtesting have proven to be reliable in many financial markets.
The information on this website does not constitute and should not be considered as financial advice, investment advice or trading advice. MakeUseOf does not advise on trading or investment matters and does not advise that any particular cryptocurrency should be bought or sold. Always conduct your own due diligence and consult a licensed financial advisor for investment advice.