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Backtesting Definition

Backtesting is a specific type of historical testing that determines the performance of the strategy if it had actually been employed during past periods and market conditions. Since backtesting uses real-world data, it has advantages over testing with synthesized data sets.

While backtesting does not allow one to predict how a strategy will perform under future conditions, its primary benefit lies in understanding the vulnerabilities of a strategy as it encountered real-world conditions of the past. This enables the designer of a strategy to "learn from their mistakes" without actually having to make them with actual money.

Additional meaning of Backtesting:

A key element of backtesting that differentiates it from other forms of historical testing is that backtesting calculates how a strategy would have performed if it had actually been applied in the past. This requires the backtest to replicate the market conditions of the time in question in order to get an accurate result.

Examples of these market conditions include screening/buying/selling stocks that no longer exist, or using market index compositions as they were in the past, rather than current compositions. Due to the expense of obtaining these data sets, backtesting has historically been performed by institutions and professional money managers. With the advent of electronic trading and more accessible online databases, however, basic backtrading has become an option for casual traders as well.

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