Backtesting, sometimes referred to as Systems testing, shows you using historical data how your Idea or System is likely to perform in the marketplace. Backtesting can answer:

• How often will I get a trade signal? Multiple signals per day or once per month?
• Do the signals occur relatively smoothly or only in clumps just a few times per year?
• What is the percentage of winners versus losers
• What is the duration of the average trade?
• What is the average winning percent of the winners and the average losing percentage of the losers?
• What is the average draw down of the winners and of the losers?
• Would this strategy have worked last week, not just two years ago.

Knowing the answers to the above questions is crucial to to help set expectations and will help you in many ways.
 

• If your Strategy doesn't work, you'll know this before finding it out the hard way when trading with real money. You will then have the chance to revise and retest your ideas until you either have a winning Strategy or you scrap it and move on to a new idea.
• By knowing the ratio of winners to losers, it should be easier to honor your stops on the losing trades after testing your various exit strategies for maximum performance. For instance, if you tested both 8% and 10% stoploss exits and found that 8% was clearly the best performer for you, then you'll be more likely to honor an 8% loss rather than hanging on and hoping for a turnaround of your trade.
• If the strategy triggers infrequently, you'll know this in advance that so that you gain patience to wait for the next setup to occur.
• By varying the time periods covered in a Backtest, you can see if a strategy that worked in the past is still performing well in the current market.
• Finally, if while examining the results of a Backtest, you find that you would not have taken the trade in the real world, you have two choices.
  1. Directly alter your Backtest strategy to reflect your personal style and rerun the Backtest to see what other trades would have be changed by your altered strategy.
  2. Consider changing your trading style to reflect what seems to be working with the Backtest results
• After you have altered your strategy and rerun it, you will have a chance to see what other trades would have been impacted by your revisions.
• What if the nature of your decision to pass on a trade is not of the type that can be expressed in the Backtest language. At minimum if you feel strongly about it, you have identified additional manual or judgmental rules that should become part of your checklist for accepting or passing on a trade.