"How does backtesting work when market regimes constantly change?"
By Dave Mabe
Here's a great question from backtesting skeptic, Jan (name used with permission, lightly edited for clarity).
Jan:
I am a bit skeptical about backtesting because, by its very nature, it always measures the past, which will, no matter what, be different from the future (or present). For example, is there a difference between testing stocks in a bullish environment (or before Trump was elected) compared to today, where the context is significantly different? How does backtesting take that into account?
Dave:
Sure, the world is constantly changing - and that includes the markets.
But that doesn't imply that everything is changing and therefore completely unpredictable.
As I'm typing this, I'm looking out my window in my office at the horizon where the sun is getting ready to rise.
I can't guarantee with 100% certainty that the sun will rise, but I would bet a lot of money on a prediction that it will.
While many things in the market change and are impossible to predict, there are plenty of patterns that do consistently repeat.
Sure, you can backtest patterns that don't repeat, but that's the whole point of backtesting:
To help you find the patterns that repeat in a consistent enough way to profit from.
Backtesting is a superpower precisely because it's a way to detect the patterns that are consistent across time.
And when you find a pattern that's consistent across market regime changes, that creates a lot of confidence in your strategy.
Notice I always use the word confidence and not certainty.
You'll never be 100% certain that a strategy will continue working (this is why you don't risk your entire account with every trade).
But you don't need to be certain to make money in the markets - you just need to have an edge.
And your edge doesn't have to be incredibly strong to make money.
Even a subtle trading edge, if it's consistent, can be very profitable. (In fact, I'd say I prefer this kind of strategy.)
Great question, Jan. I like your skeptical stance - that mindset should serve you well in your trading!
-Dave
P.S. Wish you could backtest your ideas - without spending months learning to code? Run your first backtest in an afternoon using my Amibroker AFL Course. Get Instant Access