Back Testing the Capital Markets

Backing testing historical prices is a way of creating a trading strategy as historical patterns can assist in the process of finding changes in sentiment that generate trading signal.  By using specific criteria a trader can define and develop a strategy that allows that to profitably transact in the capital markets consistently.

Examination of Back Tested Results

Prior to back testing trading strategy investors should determine if the strategy is defined in a way to fit the investors risk reward profile.  For example, conservative investors should try to avoid a strategy in which the returns are extremely volatile.  Testing should also take place over various time frames, to avoid results that only work over a small sample period.   When an analyst refines the criteria of a trading strategy or limits the historical data that is used to test the strategy, the results can be misleading and can produce returns that will not work in the future.  Investors should understand the historical results on a trading strategy are not a guarantee that a strategy will work in the future.

In fact, many analysts believe that a back tested trading strategy only proves that the strategy has worked in the past, but there is no evidence that the same strategy will work at some point in the futures.  Instead of using historical data, some back tested strategies use data that is generated by a Monte Carlo simulation.  This type of time series is randomly created and many believe this is a better guide to a potential future investment period than using historical data.

How to Back Test a Strategy

There are a number of easy to use software products that allow an investor to back test a trading strategy based on the historical prices of a security.  Many brokers offer these services as part of their overall trading package.

Investors can also back test a strategy using a spread sheet.  Data can be collected from a number of vendors such as Yahoo or Google finance, and uploaded into a spreadsheet for analysis.

The first step an investor needs to take is to determine the type of strategy they plan to back test.  An analyst will also need to decide on the time horizon they plan to use.  Short term strategies generally focus on intra-day data such as hourly data points, while longer term strategies will use daily, weekly or month data point.  Once the data is collected, an analyst can determine the type of software they will need, based on their skill set to determine if a strategy has worked in the past.

By analyzing data, a trader can develop a strategy that is in line with their financial goals, and eliminates some of the emotion from trading the capital markets.