Backtesting

What is backtesting a strategy

Backtesting is a method in which an investment or trading strategy is tested on historical data. The goal is to find out how the strategy would have worked in the past and thereby estimate its potential success in the future.

Why backtesting matters

• Verifying that the strategy works before using it in live markets.
• Identifying weaknesses and optimising strategy parameters.
• Measuring performance – for example average return, volatility or the Sharpe ratio.
• Better risk management – spotting loss periods and extreme drawdowns.

How backtesting works

1. Select historical data – price moves, trading volumes, fundamental indicators.
2. Apply the strategy – entry and exit conditions, position size, setting stop-loss and take-profit levels.
3. Evaluate the results – profitability, drawdown, win rate.
4. Optimise – tweak parameters and rerun the test.

Risks and limitations of backtesting

• Overfitting to the past – the strategy can be too "tuned" to historical data and fail in live trading.
• Insufficient data quality – errors or gaps in data can produce misleading results.
• Unrealistic assumptions – for example ignoring slippage in order fills or transaction costs.

Backtesting on Stonkee

On Stonkee users can backtest their strategies against extensive historical data on stocks, ETFs or other assets. The results are accompanied by detailed metrics, a comparison against the S&P 500 index and visual charts of portfolio performance.

Summary

Backtesting is a critical tool for any investor or trader who wants to verify that their strategy works before deploying it in the market. A correctly run backtest can significantly improve the odds of long-term success.