Importance of backtesting in automated trading

by Alpha Bot An automated trading system

Those who look at the past with a careful eye are the ones who are best prepared for the future, and this applies as much in automated trading as any other aspect of life. Are you wondering how? Let us explain.

Whenever an algorithm is written from intraday trading strategies, it cannot be simply implemented in a real life situation. The reason is that the stakes are so high in the trading business, mistakes cannot be afforded. Therefore, once the algorithm is passed and implemented in trading software, it is backtested. The process of backtesting involves using a new algorithm to make trade decisions on past data. Since the results are already known, it works as a litmus test for the efficiency of the algorithm. If the algorithm helps make the correct buying and selling decisions on the past data, it is likely that it would work on the future data as well.

Previously, backtesting was an ardous and lengthy process as it was done manually. But nowadays, three are many softwares that are ready made for testing algo trading strategies. Utilizing these software is a great way of saving time and resources. In case, you are planning about getting into automated trading, you need to keep a few things in mind.

Net Profit and loss
An experienced trader would know that there is only one goal in trading – to generate maximum profit with minimum risk. Therefore, it is always best to backtest your algo trading strategies on a broader time frame. For example, a trading strategy that gives the desired results in a time frame of 2000-2020 is much better than one that gives similar results for a time frame of 2000-2005.

Market Volatility
This term is used to refer to the inevitable fluctuations in the trade market. As a smart trader, your goal should always be to work with low volatility in order to reduce your risk while maximizing your profits.

Ratios
As is obvious from the name, some parameters are divided together to understand the nature of the stock and company. It comes in handy for managing money and in optimal position sizing. Two of the ratios that you should always be concerned with as a trader, are profit to loss ratio (P/L) and profit to equity ratio (P/E)

Average Return
The only scoreboard you’re going to have as a trader is the average return. Even though it cannot and should not be treated as a benchmark of success, it is an effective way of evaluating the success of a strategy. The more return you get from a strategy, the more successful you are as a trader.