Traders eager to begin trading in a live market frequently make the mistake of relying exclusively on backtesting results to evaluate a system’s potential. Backtesting, which refers to the testing of a trading idea on historical data to verify how a system would have performed during a particular time period, can produce misleading results. Because backtesting is only part of a proper evaluation process, focusing on backtesting results alone can lead a trader to believe he or she has a rock-star trading system when, in fact, the system may perform poorly in other phases of testing and, eventually, during live trading. Finding positive correlation between backtesting results and other phases of testing, including out-of-sample and forward performance testing, is vital in accurately assessing the jensens alpha and back testing forex of a trading system.
Backtesting allows traders to apply trading ideas to historical data to see how the system would have performed. Many of today’s trading platforms offer the ability to backtest, and provide efficient and easy-to-use methods of testing ideas on past market data. Without putting real cash on the line, traders can evaluate the effectiveness of a trading idea with a few simple keystrokes. As long as an idea can be quantified, it can be backtested — from simple moving average crossovers, to complex systems that incorporate multiple trade filters and triggers. Some trading platforms have strategy “wizards” or “builders” that allow analysts to select from a field of variables to create a custom strategy. Optimization studies are another feature that many trading platforms offer in conjunction with backtesting capabilities.
Optimization entails entering a range for a specified input — a moving average length, for example — and letting the computer perform the calculations to determine the input that has the best performance. For example, you can optimize a strategy to find the best profit target. A multi-variable optimization analyzes two or more variables in conjunction to establish what combination leads to the most favorable results. Jensen’s Alpha is a risk-adjusted performance benchmark that tells you how by much the returns of an actively managed portfolio are above or below market returns. Careful stock picking and financial engineering means that investors can add alpha to a portfolio without adversely affecting beta. The screegrabs describe the formulae used in the spreadsheet. If the returns specified in Step 1 are monthly returns, then your risk free rate has to be on a monthly basis.