Backtesting
The process of testing a trading strategy on prior time periods. Backtesting (or back-testing) is the process of evaluating a strategy, theory, or model by applying it to historical data. It can be used in situations like studying how a trading method would have performed in past stock markets, or how a model of climate and weather patterns would have matched past measurements. Instead of applying a strategy for the time period forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data in order to gauge the its effectiveness.A key element of backtesting that differentiates it from other forms of historical testing is that backtesting calculates how a strategy would have performed if it had actually been applied in the past. This requires the backtest to replicate the conditions of the time in question in order to get an accurate result. Backtesting is a common and methodologically accepted approach to research, however a high or successful correlation between a backtested strategy and historical results can never prove a theory correct, since past results do not necessarily indicate future results. In other words, things are always changing, but in a world where yesterday bears some resemblance to today, backtesting can be a useful tool of analysis and prediction.
Most technical-analysis strategies are tested with this approach.
When you backtest a theory, the results achieved are highly dependent on the movements of the tested period. Backtesting a theory assumes that what happens in the past will happen in the future, and this assumption can cause potential risks for the strategy.
For example, say you want to test a strategy based on the notion that Internet IPOs outperform the overall market. If you were to test this strategy during the dotcom boom years in the late 90s, the strategy would outperform the market significantly. However, trying the same strategy after the bubble burst would result in dismal returns. As you’ll frequently hear: “past performance does not necessarily guarantee future returns”.