Backtesting Trading Strategies

In the previous chapters, we gained the knowledge necessary to create trading strategies. On the one hand, we could use technical analysis to identify trading opportunities. On the other, we could use some of the other techniques we have already covered in the book. We could try to use knowledge about factor models or volatility forecasting. Or, we could use portfolio optimization techniques to determine the optimal quantity of assets for our investment. One crucial thing that is still missing is evaluating how such a strategy would have performed if we had implemented it in the past. That is the goal of backtesting, which we explore in this chapter.

Backtesting can be described as a realistic simulation of our trading strategy, which assesses its performance using historical data. The underlying idea is that the backtest performance should be indicative of future performance when the strategy is actually used on the market. Naturally, this will...