The Foundation: Backtesting Performance
Backtesting is the process of applying your trading rules to historical data to see how they would have performed. To determine if your strategy works, you should look for the following key metrics:
- Win Rate: The percentage of trades that result in a profit.
- Profit Factor: The ratio of gross profits to gross losses.
- Expectancy: The average amount you expect to win (or lose) per trade.
Beyond the Numbers: Analysing Risk
Maximum Drawdown
Can you survive the losing streaks? Measuring the peak-to-trough decline is essential for understanding your strategy’s volatility and whether your account can withstand its inevitable cold spells.
Sharpe Ratio
Is the reward worth the risk? This metric helps you understand if your returns are due to smart decisions or excessive risk-taking. A higher Sharpe Ratio indicates better risk-adjusted performance.
The Final Step: Forward Testing
Backtesting tells you what worked in the past. Forward testing (or paper trading) tells you if the strategy works in real-time market conditions. This step is critical because it accounts for execution factors like slippage and emotional discipline that historical data often ignores.