What is Backtesting?
Backtesting is a statistical process for validating the accuracy of a VaR model. Banking regulators require backtesting for banks that use VaR for regulatory capital. It involves a comparison between the number of times the VaR model under-predicts the subsequent day’s loss, versus the number of time such an under-prediction is expected. If losses exceeding VaR have a 1 in 100 chance of ocurring, then we expect to see 2 or 3 of those in a year. There is a lot of debate about whether backtesting is meaningful, because it is difficult to validate a model based on a few extreme events – not enough data.
Backtesting also known as Systems Testing is the concept of taking a strategy and going back in time to see what would have happened if the strategy had been faithfully followed. The assumption is that if the strategy has worked previously, it has a good but not certain chance of working again in the future and conversely if the concept has not worked well in the past, it probably won’t work well in the future. As an example, you may decide that you want to try a Moving Average crossover such as the 8 day average crossing a 13 day average. Enter when the 8 day crosses up through the 13 day and cross down when the day average crosses back down through the 13 day as shown on the following chart: The 8-13 moving average crossover looks great for the above chart but how would you go about deciding if this strategy is still a good idea across the entire market? Other than taking all trades that qualify and tallying the results for the next several weeks, the only way to decide if the approa
What is backtesting?Answer: Backtesting is the process of testing your trading system using past market data. For example, let’s say you have a system that buys a currency after every two bullish candlesticks. You can look at past market data to see how that strategy would have worked in the past.
Well, it is simply using the past performance of certain stocks in order to see if your system will work in their future stock movements. If you were back testing a system you would be following your system rules in past stock movements and see where it gets you. The idea of this is that history repeats itself. If your system worked in the past movements then it will probably work in the future. That does seem to make some sense after all. It is considered to be very valuable, but it also does have its flaws. Even though it could tell you your system works it will not show you how it works in different market postures. It could be that it works very well during a bulls market but very poorly during a bears market. It could also be the opposite working well during bears markets but poorly during bulls markets. Or it might leave you unprepared for such surprises like new events or bigger market news. It is for those reasons that many market professionals will tell you the famous quote “p
