To consistently profit in trading, it is crucial to develop a personalized strategy that suits your nature. However, there are various ready-to-use trading strategies available.
For example, you can focus on support and resistance levels by utilizing Fibonacci numbers, ride momentum with RSI and EMA, or base your trades on candlestick patterns.
However, developing a strategy is just the first step — the next, arguably most important, is testing its reliability to confirm its robustness in various market conditions.
One method of evaluating it is backtesting, which allows you to find the strategy's weaknesses and avoid real-money losses.
What is backtesting?
Backtesting is a method traders use to test their trading strategies by using historical data to prepare for real trading.
Some platforms even simulate historical price action as if it's happening in real time, allowing you to practice decision-making under realistic conditions.
For example, this is how your gold price chart may look today, if you were to backtest your strategy using gold price data starting from January 2021.
It’s important to remember that a strategy's success rate doesn’t determine its effectiveness. Some strategies have a large number of losing trades, but due to precisely calculated stop-loss orders and high gains from successful take-profits, their profits-to-loss (PnL) ratio remains high.
Backtesting benefits
Before you start, here are several reasons why backtesting is a critical step in developing a working strategy:
- It's completely safe — backtesting is a simulation. It doesn't require real money or any kind of deposits.
- Helps you get a complete picture of your strategy's performance.
- Helps mitigate risks of potential losses by conducting preliminary testing rather than directly implementing it in the real market conditions.
- Increases your confidence in trading.
- Helps you understand the asset's price movements — each asset is unique and requires a thorough understanding.
Before you leap into backtesting, there are some things to consider:
- Choose one asset to test — even well-performing strategies often don’t translate well across different assets.
- Stick to a single timeframe to avoid misleading conclusions.
- Define your strategy clearly, including entry and exit price levels.
- Determine the risk you can tolerate.
- Set the backtesting period — the longer the period, the more accurate the results.
- Use the data from the exchange where you will trade — relevant data is a must for backtesting.
- Track and analyze your backtesting results — record such as risk-reward ratio, drawdown, PnL ratio, and others. You will then need this data to make adjustments to your strategy.
Once your strategy has proven to be successful, you may then try real-money trading. But it's advisable to start with small positions to build your confidence and test yourself under real market pressure.
As your comfort and consistency grow, gradually increase your position sizes.
Real trading involves following rules and sticking to them even if you feel that "something goes wrong." This is achieved through discipline, patience, and confidence. Money management and risk management techniques are also crucial components to protecting yourself from unpredictable losses.
The market will always be there. Taking the time to backtest thoroughly is an investment that consistently pays off.