While obviously, we can't see into the future, we do have sufficient data from the past to be able to backtest strategies and trading ideas. While not the most glamorous of activities, it allows you to hone your trade execution only skills, ready for the next trading opportunity. So, what are the specific benefits of backtesting?
Prove your trading strategy works
Many of us have trade execution strategies in our minds; they seem relatively simple and easy to understand. However, the key to a successful trading strategy is testing it in the real world and proving it works. Looking back, we have the numbers, the graphs, and emerging technical indicators, all readily available. This is an essential part of backtesting for any execution-only trader, whether looking to invest on a daily basis or longer-term. Make sure you test, test and test again!
Maybe you should also consider stress testing trades you carried out in the past? Could you have made any changes?
Self-discipline
Timing and self-discipline are two very important factors when looking at trade execution. Thankfully, backtesting, done correctly, allows you to test your self-discipline and execution-only skills. For example, would you be tempted to buy before a trend emerged? Would you be tempted to sell too early, missing out on the next upward leg? Try, try, and try again, testing yourself and your nerve – ready for the real market!
Tweaks and adjustments
While you may have hit on a potentially lucrative trade execution strategy, it is unlikely that you will have the finished perfected system from day one. As an execution-only trader, you need to be flexible, make adjustments and tweaks, and be ready to adapt. Testing, testing and retesting against historical data will allow you to try various adjustments. Some may enhance your strategy, and others may be detrimental, but it is essential to test them out.
Test under different market conditions
Over the years, we have seen many traders shouting about their winning strategies, trade execution masterpieces, which have made them a fortune. However, as execution-only traders get more and more confident, some will make the mistake of going big or all-in on one trade. You may not get the overall picture if you have not tested your strategy under different market conditions, bull markets, bear markets, or flat markets. This could have a massive impact on your trade execution successes!
Real-time testing of trading opportunities
While nothing is set in stone, if you can tweak and adjust your trading strategy until you have the utmost confidence, this is a priceless position. As you go through the process in real-time, this should throw up several execution-only trading opportunities. The in-depth backtesting has given you the confidence to look for the indicators and carry out your trade execution at the perfect time. Like an animal waiting for that opportune moment to pounce on its prey!
How much backtesting should you do?
How long is a piece of string? It would help if you carried out as much backtesting as needed to prove that your strategy works (or doesn't), introduce improvements, and then test it in the real world. Of course, in a perfect world, you should be looking for flaws in your strategy when doing your backtesting.
Many execution-only traders, especially those in their early days, tend to look for results to back up their thoughts. We need to find strategies to fit the market, not market movements to fit our "flawless strategies". Contrary to popular belief, backtesting is not there so that execution-only traders can pat themselves on the back. It is there to push, challenge and test your strategy under various conditions.
Summary
In the glamorous world of day trading, backtesting is probably the last thing on your mind. Trade execution is the main focus of all execution-only investors. Time spent backtesting and looking over old data is seen by many as time wasted. However, remember when backtesting, you are not only stress testing your strategies but also your ability to carry them out. These are both critical elements for any execution-only trader.