Back testing software is an integral cog in the process of analysing trading systems. Back testing is the process of testing a trading strategy using historical data rather than testing it in real time with real money. The metrics obtained from testing via back testing software can be used as an indication of how well the strategy would have performed had it been applied to past trades. Interpreting these results then provides the trader with sufficient metrics to assess the potential of the trading system.

Logically, we know that the results from this type of testing will not be able to predict future returns with pinpoint accuracy; however, it can provide an indicator as to whether you should even pursue a trading system or not. What's more, if you decide to go ahead and trade the system, it will give you guides on what to expect.

But the question remains: how can you test a trading system's performance over time? There are only two ways to do this - manually or with computer software. To be honest, computer software is the only 'real' option. I have done both testing methods and manual testing is not only time consuming but very hard to replicate and test effectively.

The benefits derived from back testing software cannot be underestimated. It will save you time and provide an endless opportunity to fine-tune and test your system. A small outlay in capital to purchase good back testing software will potentially save you thousands in the market; it is a very wise investment if you are considering designing a successful and mechanical trading system.

Mechanical Back Testing

Please understand, as long as your mechanical trading system exclusively works with price data (open, high, low, close, volume), you will be able to use back testing software.

For example, say you create a mechanical trading system with the following entry rule:

Purchase a security when the 10-day moving average of closing price crosses above the 30-day moving average of closing price.

This rule can be tested quite easily over historical data. On the other hand, if your buy signal rule was a little more complex such as:

Purchase a security when the 10-day moving average of the closing price crosses above the 30-day moving average of closing price and the PE ratio was 75% or lower than its value three months before.

This rule introduces data that is not often supplied or maintained in a database of price information. To successfully back test this would involve obtaining historical data of a security as well as the price-to-earnings ratio (PE ratio). Typically, historical data on a group of equities would only include the open, high, low, close and volume for each period. Because of this limitation, many mechanical trading systems are designed around purely price technical indicators.

Unfortunately most mechanical trading system based on fundamental data is beyond the scope of retail investors due to the lack of historical data available to conduct a complete back test.

Back testing software

Fortunately, these days, many charting packages have back testing software built in. If you followed the process for selecting a charting package in the previous chapter, you should have either found one with back testing capabilities included or found one that is compatible with another off-the-shelf package.

I believe back testing is the only way to remove self-doubt. Once you have established that you have a reliable and robust trading system only then will you be confident in trading it.

Similarly to your charting software, make sure you know your back testing software back to front. You won't be able to get the best out of it unless you fully understand how it works and what you can do with it.