Trading strategies are systematic ways by which traders execute trades in the market.
Finding the right strategy for you is not always easy. There are a series of trials, errors, and failures before you are able to decide which trading strategy is best for you. Also, different asset classes require different investment approaches, hence different strategies.
Inability to find the appropriate trading strategy could lead to losses for your portfolio. Backtesting is an important part of developing your mettle as a trader. This article highlights the importance of backtesting strategies before you use them in live trading.
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5 Reasons Why You Should Backtest Your Trading Strategies
1. Helps prevent losses
Backtesting your trading strategy helps to prevent losses.
Going into a trade without a strategy is akin to crossing the freeway with a blindfold on. Going into a trade with an unrest strategy is similar to gambling. It is a recipe for portfolio suicide.
When you back-test your strategy, you know its success rate. You also identify the best time to use it and in which asset class. If you want to score multiple successes as a trader, you can’t execute your trades on mere chance.
2. Identification of niche opportunities
Strategies are borne out of hypothesis.
A trader has an idea of how to be exposed to a particular asset or sector. To test the effectiveness of this theory they decide to test it in simulation trades. In doing so, they may discover an approach that has not been used before.
Every trading strategy was first a hypothesis until it was tested over a long period. Backtesting your trading strategy could open up a new way to invest in an asset, thereby giving you an edge over other traders that would be depending on more popular strategies.
3. Develops a trading style
Part of your growth as a trader is developing your style.
This is borne out of your risk appetite, philosophy, bias, knowledge, and experience. For example, some traders focus on scalping, while others may find swing trading to be their forte.
Similarly, backtesting your strategy before you use it in live trading helps to develop your own style as a trader, thereby giving you an identity. In doing this, you would not be easily swayed by the emotions in the market as you would have the conviction in your strategies and trading abilities.
4. Leads to in-depth understanding of technical tools
Backtesting trading strategies leads to a greater understanding of technical tools and how best to use them in your analysis.
Before you find a strategy that suits your trading plans and objectives, you would have tested a lot. It is similar to rummaging through piles of trash to find a gem.
By testing multiple strategies, this leads to a better understanding of which tools are best suited for a time frame, market cycle, or particular asset. For example, oscillatory technical indicators such as MACD histogram or Bollinger bands are slower to reflect the change in trends unlike technical indicators such as RSI indicator or Parabolic SAR.
As such, backtesting leads to a more in-depth knowledge of technical indicators which makes you a better trader in the long term.
5. Gives you confidence as a trader
When you have tested your strategy in multiple scenarios across different time frames and market cycles, you would have the confidence to proceed as a trader.
As such, you would depend less on others for opinions or strategies. You have to understand that every trader approaches the market differently. This difference in approach is a function of behavior, experience, capital amongst other things.
Tailoring your trading strategy on the opinions of others is a futile way of approaching the market or any investment.
A Warning Note
Backtesting is not always the most accurate way to gauge the effectiveness of a given trading system.
Sometimes strategies that performed well in the past fail to do well in the present. One major mistake traders make is assuming that all market scenarios are the same. Past performance is not indicative of future results.
Be sure to paper trade a system that has been successfully back-tested before going live to be sure the strategy still applies in practice.
Key Takeaway
Backtesting is one of the most important aspects of developing a trading system.
If created and interpreted properly, it can help traders optimize and improve their strategies, find any technical or theoretical flaws, as well as gain confidence in their strategy before applying it to live markets.
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