This is actually a common topic in the crypto space but not really common if you don't know what is involved. Many needs a recap of setting things because the more we advance in our knowledge, we tend to drop old or previous knowledge that can be of help to use in making good trading decisions. Let's assume you are a chef in a big restaurant and you want to launch a new recipe….
Instead of serving it to customers first, you tastes it to see if everything including ingredients and method of preparation is on point to avoid embarrassment or losing customers. After tasting the meal, you'll know if it's ohkay to be served or not. You'll know what is lacking and what is too much. With this, you'll hit your menu and storm your launch. This applies same to crypto.
As you did a back test so to speak to check if everything is on point. You'll also need this method sometimes as a strategy on past market data before risking your money on trading. This minimises chances of losing when you finally hit the market.
This is actually a strategy most newbies on the crypto space need to use. The world is revolutionizing in a way that almost everyone wants to be part of the crypto space and this revolutionizing will bring about lot of scams, failures and losses to newbies if they lack the basics of crypto.
Backtesting is a strategic method used by traders to check or determine how effective their trading strategy using some tools is when applying it to historical market data. It involves taking a strategy you feel would work for you when you place a trade in the volatile market and then see how this would have performed in the past.
This method actually helps one determine if the strategy they want to use in trading would be profitable before using their real capital. The back testing framework has components which makes it up and these includes; the formation of your trading strategy which involves understanding market indicators and how to use them, market tends abd some signals that predict the movement of the market.
Metrics for evaluating includes the profit and loss, win rate and shape ratio which forms the component of this strategy. Then we have the historical data collection which is the backbone of this testing. You'll need records of past market activity and you can get these using some trading platforms.
There are some steps to follow when carrying out this backtesting. You'll need to obtain the historical price data of a particular asset, its trading volumes and some other information. You'll also need to structure the data in a format that's easy to work with.
After this, you'll outline the criteria for buying and selling based on moving averages, price movements etc. You'll also need to use the back testing trading platform you want to use to apply your strategy to past data. The platform will help you simulate buying and selling based on what you inputed.
You'll then need to evaluate the market with regards, profit and losses, win rate etc. This will help you understand the performance of the strategy you want to use. Identify any patterns or trends the result of your testing and then adjust of necessary.
There are different types of back testing……which includes Trends following strategy which involves the idea that prices move in the bullish or bearish direction over a period of time. You'll need to identify the trend using technical indicators like the moving average and then enter the trade when it's either bullish or bearish.
When It hits your target after following these trends, you'll sell. The next type of back testing is Mean Reversion Strategy which implies that prices of an asset returns to their mean level after deviating. Traders usually use the Relative Strength Index for this type of back testing.
We have the arbitrage and the momentum strategy which uses Indicators like the MACD etc. Why is back testing important?
Back testing helps you identify potential problems in the market to avoid losing money on a trading strategy that doesn't work for a particular trade.
It gives you confidence in using your trading strategy effectively with a clear target when placing trades.
Despite these trading strategies, there are some disadvantages of which one include over fitting and ignoring market frictions like slippage and liquidity issues which isn't too good. These can impact the performance of a trading strategy using the back testing.
I bring it forward to you that it seems the market will repeat itself but this shouldn't influence your trading decision. It's just my analysis. The market can change at anytime and may not follow its past. Take a look at what happened in July, 2021….the bitcoin halving year. Bitcoin increased a bit from its lowest low they month to a certain level. I.e from $28k to $36k and this happened during 11th July down.
This is what is also happening this month. Bitcoin has its lowest low this month at $53k and has increased to $58k. Will it pump to $62k before it drops again to $54k as shown in the candle sticks or will it dump. Let's be watchful. So far, it has played what the market played last bitcoin halving on July. The candlesticks looks almost the same movement. We can try a back test on any tool using this data.
Disclaimer :Any financial and crypto market information provided in this post was written for informational purposes only and does not constitute 100% investment advice. It's just basic knowledge every crypto trader or investor should have
In conclusion, the back testing is a method of checking if your trading strategy would be effective for use in trading to avoid losses or make it minimal. This is actually good as it helps us understand how effective these strategies are through past market data.
All screenshots are from my binance.