Financial Glossary: Back Testing


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Back Testing

Back Testing

The process of designing a trading strategy according to historical data and then testing the strategy by applying it to fresh data.

Instead of applying a strategy for the time period Forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data in order to gauge the its effectiveness.

Most technical-analysis strategies are tested with this approach.

When you back test a theory, the results achieved are highly dependent on the movements of the tested period. Back testing a theory assumes that what happens in the past Will happen in the Future, and this assumption can cause potential risks for the strategy.

For example, say you want to test a strategy based on the notion that Internet IPO's outperform the overall market. If you were to test this strategy during the Dotcom Boom years in the late 90s, the strategy would outperform the market significantly. However, trying the same strategy after the Bubble burst would result in dismal returns. "Past performance does not necessarily guarantee Future returns".

Posted by ebs Finanzakademie GmbH

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