In response to yesterday’s post on which backtesting software is worth considering, reader Kyle Kaefer from kpsoundcompany.com and Concordia University asked (sharing with permission):
Kyle:
I do not run backtests because I am just getting my first couple of bots up and running on paper, but… if you have a good understanding of your niche edges, could forward-testing in a paper account be just fine?
It seems like backtests more often than not fool us as traders.
Dave:
That’s a great question. I think you can get by without it, but only if you have a really strong sense of your niche edge. And even then, even with the imperfections of backtesting, it can be really valuable to what you’re doing with your bot and forward testing.
I think a lot about a trader’s “path to confidence.” It’s easy to trade with small size, but what’s in the way of you trading with your full size for a given strategy? It’s likely that there are some unknowns about how the strategy will perform in the future.
Those unknowns will fade over time with just forward testing and experience, but imagine if you had a backtest to use as a guide. Your path to trading with full size could be very short since you can very quickly check each day how your trades are measuring up to the backtest.
From there, you can extrapolate and understand quickly what results you could have expected had you started trading the strategy months ago (even several years).
That can be extremely valuable because it provides a much quicker path to confidence.
Now, imagine a year from now, and this strategy is in a drawdown. Is this level of drawdown normal for the strategy? It’s hard to answer that without a backtest.
Kyle:
I totally would and will eventually backrest, just not there yet, you make very valid points! I am probably overconfident, but I do think what I have is sound and will, at a minimum, break even… been in and out of markets for 10 years, so I have some experience.
Dave:
Well, there are two paths to confidence: trading experience and backtesting. The former is the most important one, but it takes time to cultivate it. Since you already have a healthy dose of it, backtesting will be that much more valuable when paired with your trading experience and intuition.
Thanks for the question, Kyle!
-Dave
