To develop a trading strategy, most use technical and/or fundamental analysis.
Technical analysis primarily utilizes historical trends of price movements as indicators of how a security will perform going forward. It can also look at other historical trends such as trading volume. Technical analysis operates under the fact that the market and price movement tends to repeat itself in patterns.
Fundamental analysis differs as it is intended to help the investor find the real value of a security, which after comparing to the current market price, identifies if it is being over or undervalued. This process looks at anything that could possibly factor into the value. This includes looking at information from financial statements to examining the impact of current economic or political factors on the value of a security.
Many use one or a combination of both to create a trading strategy. However, to help generate the best results, all trading strategies should be tested with tools such as backtesting or forward testing before being executed.
Backtesting helps the trader see how successful a trading strategy would have been had the trade been executed in the past under similar market situations. It essentially simulates how well a certain trade idea would have performed and allows the trader to see just how risky a potential trade strategy would be.
Let’s say, for example, that you have a trading strategy and see that in the last 10 minutes, Natural Gas went up 5%. A backtester might indicate that in a similar circumstance when that happens, the desired trade is successful in reaching its profit target 80% of the time. As technical analysts understand that price movement tends to repeat itself and occurs in patterns, the trader would likely be comfortable executing the strategy in this instance.
There are two methods of backtesting: automated and manual.
Manual backtesting is extremely tedious and time consuming. In this method, you can print out and analyze charts to see what happened in nearly identical instances.
Automated backtesting is much more efficient as a program can let you know the success rate of the trade idea based on past historical data and all relevant charts almost instantaneously. While this method is preferred, it often requires the use of an expensive platform or developing advanced software/coding.
This tool can be seen as almost the opposite of a backtester. With forward testing, a trader can test a trading strategy with the real market or a simulated one. It relies on seeing how a trade strategy would play out in the present rather than focusing on past data.
It is also known as paper trading, as no real money is exchanged. Forward testing is simply a simulation of how a trading strategy will perform.
Paper trading can be done in a couple different ways. Traders can forward test by following the live market and recording potential trades by hand, or by using an online market simulator which is intended to be similar to current market conditions. Many brokerage firms provide software for the latter as it helps traders and new learners seamlessly transition from testing their strategies to implementing them in reality.
However, because these methods do not involve the use of real money, forward testing can downplay the risk of the situation. For the best results, every move the trader makes while forward testing should be done with the belief that they would actually make those trades with real money.
Also, if you use a simulated market, the market conditions may not be exactly the same. This is important to note before implementing any trading strategy after forward testing.
As it can be useful to see if history backs up a trading strategy and how it would play out in the present, backtesting and forward testing are important trade testing tools to help a trader reach success in the market.