What is backtesting?

1. Rule: enter when a 4h candle closes above the three-week range high with volume above 1.5x its 30-day average.
2. Exit: a 3% trailing stop, or a close back inside the range.
3. The backtest steps through every 4h candle in the test period, checks the entry rule, simulates each trade and applies the exit.
4. The output is the full list of trades plus summary figures: net return, max drawdown and trade count.

• Evidence before risk. A backtest shows how an idea behaved on history before any money depends on it.
• Look-ahead bias. A backtest must only use information that was available at each moment. Using later data makes results look better than they could have been.
• Overfitting. Rules tuned until they fit the past perfectly often fail on new data.
• Costs and sample size. Check which costs such as fees are included, and whether there are enough trades for the result to mean something.

Related terms

• Overfitting →Overfitting is when a trading strategy is tuned so closely to past data that it captures noise instead of a real pattern, and then fails on new data.
• Max Drawdown →Max drawdown is the largest fall in a strategy's or account's value from a peak to a later low, expressed as a percentage of that peak.
• Net Return →Net return is the total percentage gain or loss of a strategy or investment over a period, measured from its starting value to its ending value.