A COMPLETE step-by-step guide on how to backtest for FREE

Introduction

Starting your first backtest can be a bit like trying to solve a puzzle blindfolded. There’s a whole bunch of knobs and dials to get just right—from historical data to the nitty-gritty of your strategy’s rules. 

But don’t worry, this guide’s got your back. We’ll walk you through the steps, one by one, so you can nail down those backtests with the precision of a pro. Accurate backtesting? It’s like making sure your GPS is spot-on before a big road trip. It’ll save you from taking wrong turns and help you cruise confidently towards your trading goals. Let’s get you set up for success.

What are the benefits of backtesting?

Pros of Backtesting:

1. Risk-Free Simulation: Test strategies without losing money.
2. Historical Insight: Understand how your strategy would have performed in past market conditions.
3. Strategy Refinement: Identify and fix issues before going live.
4. Confidence Building: Gain assurance in your strategy’s potential.
5. Data-Driven Decisions: Make informed choices based on quantitative evidence.

Cons of Backtesting:

1. Overfitting Risk: Tailoring a strategy too closely to past data may not work in the future.
2. Quality of Data: Reliable historical data can be expensive or hard to find.
3. Market Changes: Past market conditions don’t always predict future movements.
4. Emotional Factors: Backtesting can’t simulate the emotional impact of real trading.
5. Time-Consuming: Comprehensive backtesting requires significant time and effort.

Different parameters of running a backtest

When you’re running a backtest, think of it as setting up a science experiment. You’re the mad scientist, and every parameter you adjust can totally change the outcome. Here’s the lowdown on the details you need to nail:

1. Historical Data: This is the backbone of your backtest. You’ll need price data from the past for the assets you’re trading. The more, the merrier, but also the more accurate.
2. Strategy Rules: These are your trading signals. What’s going to make you say “buy” or “sell”? You need clear-cut rules so there’s no second-guessing.
3. Risk Management: Decide how much you’re willing to risk on each trade. This is your safety net to make sure one bad trade doesn’t wipe you out.
4. Costs: Don’t forget about the costs like fees and slippage. They can nibble away at your profits if you’re not careful.
5. Timeframe: Are you day trading or looking at the long haul? Your backtest should reflect the time frame you’ll be trading in.
6. Benchmarking: You’ll want something to compare your strategy against, like an index or the overall market performance.
7. Statistical Measures: You need to know how to measure success. Are you looking at overall returns, risk-adjusted returns, or something else?

Step-by-step guide

1. Sign up on AlgoTest here to immediately get 25 free backtests
2. Login and click the ‘Create Strategy’ on your dashboard
   
3. Select your preferred index and instrument in this section. The underlying instrument could either be the Cash instrument (eg NIFTY index) or the Future instrument (eg NIFTY front month future).
   
4. Add your entry settings
   
5. Add legwise settings here
   
6. Build your specific legs here. Click on ‘Add leg’ to add multiple legs
   
7. Set your overall strategy setting here
   
8. Enter the date range for your backtest
   
9. Click on Start Backtest to begin

Example Case Study

Case Study 1: Backtesting the Nifty 50 Index Using the SMA Crossover

Raj, a beginner trader in India, decides to test a strategy using the Simple Moving Average (SMA) crossover on the Nifty 50 index.

1. Defining the Strategy: Raj chooses a strategy where he will buy when the short-term 10-day SMA crosses above the long-term 30-day SMA and sell when it crosses below.
2. Setting Up the Test: Using a backtesting tool, he inputs the SMA parameters and runs the simulation.
3. Evaluating Results: The backtest indicates that the strategy would have yielded a modest return, but also highlights periods of significant drawdown.
4. Refining the Strategy: Raj decides to add a filter based on the overall market trend and a stop-loss condition to minimize losses. He reruns the backtest with these new parameters.

Case Study 2: Testing the Momentum Strategy on Indian Stocks

Priya, another new trader, wants to backtest a momentum strategy where she buys stocks that have performed well in the past with the expectation that they will continue to do so.

1. Defining the Strategy: She selects stocks from the S&P BSE 100 that have had the highest returns over the past six months.
2. Gathering Data: Priya collects historical price data for these stocks over the last five years.
3. Setting Up the Test: She sets up the backtest to buy these stocks and hold them for one month before reassessing.
4. Evaluating Results: The backtest shows high potential returns, but also significant volatility and drawdowns during market corrections.
5. Refining the Strategy: To mitigate risk, Priya incorporates a volatility filter to exclude excessively volatile stocks from the selection and adjusts the holding period based on market conditions.

These examples illustrate how Indian traders can backtest their strategies using local indices and stocks, adjust parameters according to their risk tolerance, and refine their approaches based on the backtest results.

What if I want feedback on my backtest?

If you want feedback on your backtest, you can head to our Telegram community (100% free) to discuss your strategy with 5,000+ other members. 

What to do after a backtest?

After you’ve run a backtest, here’s what you should do:

1. Analyze the Results: Look at the profits, losses, and any patterns that emerge. Ask yourself if the results meet your expectations.
2. Check for Overfitting: Make sure your strategy isn’t too tailored to past data, which could make it less effective in real trading.
3. Adjust Your Strategy: Based on the analysis, tweak your trading rules if necessary. Maybe you need to adjust your risk management or entry and exit points.
4. Validate with Out-of-Sample Data: Test your strategy on a different time period to see if it still holds up.
5. Forward Testing: Consider paper trading your strategy in real-time to see how it performs in current market conditions.
6. Seek Feedback: Share your backtest results with experienced traders or mentors to get their insights.
7. Prepare for Live Trading: If everything checks out and you’re confident, you can start trading with real money—but start small to test the waters.

What’s the best free tool to start backtesting?

AlgoTest is one of the best free tools to start backtesting. If you’re starting out, you can sign up and execute up to 25 backtests for free every week. Not only is AlgoTest free, fast, and accurate, its edge is that you can virtual trade on the same strategy to refine it, and start live trading by connecting with your existing broker – all within AlgoTest.

P. S – Backtest your trading strategies within seconds for free. Sign up here.