While not the most glamorous aspect of trading, backtesting is crucial for developing a successful crypto trading strategy. In this article, we’ll explore the importance of backtesting, its advantages and disadvantages, and the different methods available for backtesting your crypto technique.

What Is Backtesting in Crypto?

Backtesting is a method for evaluating the effectiveness of a crypto trading strategy by simulating its performance using historical price data. This process helps traders understand how their strategy would have performed in the past, providing valuable insights into the likelihood of positive results in the future.

By analysing the outcomes of their strategy over a large amount of crypto backtest data, traders can identify potential strengths and weaknesses, fine-tune their systems, and ultimately build confidence in their decision-making processes. In essence, backtesting is a risk-free way to assess and refine trading strategies before deploying real capital in the volatile cryptocurrency market.

Reasons Traders Backtest a Crypto Strategy

Backtesting offers several advantages that can help improve your trading performance and confidence in your strategy. Here are four key reasons why traders backtest your trading strategy.

Preparation for Live Trading

Using historical data to see how your strategy would have performed allows you to prepare for live trading. Instead of diving headfirst into the markets, taking the time to understand how your strategy really works through backtesting will enable you to make improvements and identify any gaps in your knowledge.

Reduces Risk

Backtesting, like other forms of testing, mitigates your overall risk. The main risk in trading is losing hard-earned capital. Backtesting reduces the chances of losing capital, both by helping to develop your understanding and by determining whether your strategy works in the first place.

Build Trust in Your Trading Strategy

The backtesting process exposes you to various market conditions and situations, offering an overview of how your strategy performs under different circumstances. Consequently, you can develop greater trust in your trading strategy and gain the confidence needed to execute trades consistently.

Generate New Ideas

Studying historical data can reveal repetitive patterns in the market that are directly related to your strategy, helping to spark new ideas and approaches that may increase your chances of success.

Two Ways to Backtest Your Strategy

There are two primary methods for backtesting a crypto trading strategy: manual and automated. Each approach has unique advantages and drawbacks, so choosing the right method depends on your preferences, skills, and available resources.

Manual Backtesting

Manual backtesting involves examining historical price data with your own eyes and applying your trading strategy to see how it would have performed in the past. This hands-on approach requires you to scroll through charts, identify trade setups, and manually calculate the profit and loss for each trade. Here's how to perform manual backtesting:

1. Open the chart of your preferred crypto asset, and set it up as outlined in your strategy. This might mean initialising any indicators your strategy uses, setting a timeframe, or highlighting specific areas.

1.1. In this example, we’re using a simple moving average (SMA) crossover strategy on the 1-hour chart to enter and exit trades when the 20-period SMA crosses the 50-period SMA.

2. Find a suitable place to begin the backtest on your chart. Aim to balance covering a large amount of data and not making the process unwieldy with too much data. Enough price action for 20-30 setups is a good place to start.

3. Move the chart candlestick by candlestick. In other words, watch the far right of the chart and move forward slowly. In most trading software, this can be done by tapping the right arrow key on your keyboard.

4. Identify trade setups that align with your strategy, staying aware of your rules and aiming to replicate how you would trade for real.

4.1. Here, we would look for the crossover before noting an entry and exit.

5. Document the results. This can be done on pen and paper if desired, but a spreadsheet is often your best bet. A spreadsheet lets you easily calculate profit/loss ratios, average risk/reward ratios, and other statistics. It’s a good idea to include a couple of sentences about the setup, the date and time, and a screenshot alongside other necessary data, like profits and losses.

6. Repeat the process, ideally over at least 20-30 trades, to gather a decent sample of data. There’s almost no downside to extending this to 50-100 trades, although you may want to break this up into multiple backtesting sessions.

Manual backtesting involves elements of trading psychology, which can help you master psychological pitfalls faster. However, it can be time-consuming, and you’ll likely make some mistakes that may skew your results.

Automated Backtesting

Automated backtesting streamlines the process by using technology to test your trading strategy. This method typically requires coding and applying your strategy to historical data, allowing the software to calculate outcomes automatically. Automated backtesting works similarly to manual backtesting, with the primary difference being the speed and convenience provided by technology.

There are many avenues available to traders looking to backtest automatically. The popular MetaTrader 4/5 platforms have backtesting capabilities, as does FXOpen’s native TickTrader platform.

Dedicated cryptocurrency backtesting platforms, like Cryptohopper, tailor the experience to crypto traders and can even remove the need to code a strategy. These no-code crypto backtesting platforms may be less versatile than coded solutions.

To perform automated backtesting, you'll need to choose a timeframe, trading asset, and strategy, just like with manual backtesting. However, the entire process is carried out automatically, allowing you to evaluate your strategy's performance over large data sets more efficiently. The main challenge of automated backtesting is possessing the skills necessary to code your strategy or the resources to hire someone who can.

Drawbacks of Backtesting Your Strategy

While backtesting your crypto trading strategy can provide valuable insights, it's important to keep in mind that the process has some limitations.

Historical Success Doesn't Guarantee Future Results

Just because a strategy performed well in the past doesn't mean it will continue to do so in the future. A once profitable strategy may become less effective as new trends emerge or market dynamics shift. This is why forward testing with a demo account is a way to confirm your strategy's effectiveness.

Overfitting

Overfitting is a bigger issue in automated backtesting, although it does apply to manual testing. Overfitting means adjusting your strategy to produce optimum results on historical data and assuming that these are the perfect parameters for future performance. While some amount of tinkering is likely a good thing, too much can give a false impression of your system's results and lead to frustration, and potential losses, down the line.

Volatility and Market Influences

The crypto market is known for its volatility, and the performance of Bitcoin and overall market sentiment heavily influence the price of many cryptocurrencies. This can make it more difficult to identify consistent patterns or develop effective strategies across various conditions than in other asset classes.

Choosing Your Backtesting Style

Whether to use manual or automated backtesting depends on your individual needs, preferences, and resources. Consider these factors when choosing your backtesting style.

Time Commitment

Manual backtesting can be time-consuming, especially if you're analysing a large amount of data or working with multiple timeframes. Automated backtesting may be a more efficient option if you have limited time available for backtesting.

Technical Skills

Automated backtesting requires knowledge of coding or access to someone who can help create the necessary software. If you're not comfortable with coding or don't have access to help, manual backtesting may be more suitable.

Emotional Involvement

Manual backtesting can help you better understand your trading psychology and emotional reactions to market movements. This approach may help improve your decision-making process when live trading.

Accuracy

Automated backtesting can process large amounts of data quickly and accurately, minimising the risk of human error. Automated backtesting may be the better option if you're looking for a more precise and objective assessment of your strategy's performance.

Ultimately, the choice between manual and automated backtesting will depend on your specific needs and circumstances. You may even find it helpful to use a combination of both approaches to gain a deeper understanding of your strategy's performance.

The Bottom Line

In summary, backtesting is an essential tool for any crypto trader looking to develop and refine their trading strategy. It may seem arduous, but your trading performance will thank you for it.

While these tips are tailored toward crypto, they can largely be applied to whichever asset class you prefer to trade, like forex, stocks, and commodities. Once you’re done backtesting, you can open an FXOpen account to gain access to these markets, the advanced TickTrader platform, and more. Alternatively, you can open a free demo account if you’re looking to begin forward testing your strategy. Good luck!

At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.

This article represents the opinion of the Companies operating under the FXOpen brand only. It is not to be construed as an offer, solicitation, or recommendation with respect to products and services provided by the Companies operating under the FXOpen brand, nor is it to be considered financial advice.

This article represents the opinion of the Companies operating under the FXOpen brand only. It is not to be construed as an offer, solicitation, or recommendation with respect to products and services provided by the Companies operating under the FXOpen brand, nor is it to be considered financial advice.