Crypto Backtesting – The What, Why, And How
Whether you’re a novice trader or you have been trading for years, if you don’t do backtesting to choose a great strategy, then you’re missing a lot.
You’ve probably got a lot of questions. What is crypto backtesting? How does it work? Why is it so great? We’re going to answer all these questions and more. Are you excited to learn more about crypto backtesting? Awesome! Let’s start!
What Is Crypto Backtesting?
Crypto Backtesting is the process of looking at the viability of a crypto market or a strategy. You should do backtesting when you’re exploring a new market or a strategy.
Backtesting is effective because it involves studying the historical data to choose a good market and a strategy. By studying historical data, you would learn a lot more than by simply trading cryptocurrency. This is because by studying historical data, you’re analyzing an extremely large database that includes tens of thousands of traders. Whereas, when you only study your investments, you are just analyzing data from one person’s experience.
Alright, but what do you exactly get by studying historical data. You get to know the risks and benefits of investing in a market and using a strategy.
You should choose the market, and the strategy based on the risks and rewards. If the risk of investing in the market (price fluctuations) is too high and the rewards are not much, then you shouldn’t invest in that market. The same goes for the strategy.
However, there can be an exception in the case of strategy. If you can modify the strategy and make it better, then it’s fine to give it a go. When analyzing markets, it’s important to consider the market condition. The data of the assets in different market conditions are usually extremely different.
Most crypto traders can benefit by using backtesting, and in many cases, such as automated trading, it’s essential to do backtesting.
Now that you’ve got a basic understanding of crypto backtesting, let’s talk about how backtesting works.
How Crypto Backtesting Works?
The assumption behind crypto backtesting is that what worked in the past will work in the future. To start, you have to become familiar with the negative and positive signals that define whether a strategy is viable and you have to learn how to analyze the historical data.
Once you know how to do these two things, then you can start backtesting. All you have to do now is analyze the chart, find out whether the signals or negative or positive, and then decide whether the strategy is a go or no-go.
So far, crypto backtesting seems super simple. But, it truly isn’t? What we have told you so far doesn’t include an essential factor. Data from a particular market environment doesn’t matter much for another.
This factor makes things much more difficult. Why? Because getting your hands on past data that can also be used for the current market environment is extremely difficult. There isn’t one, but two reasons that make it super difficult to find the right data. Let’s look at both reasons:
- Many backtesting data providers are not trustworthy
- Market conditions move constantly
Next, let’s talk about when you want to backtest a strategy. This doesn’t mean that it’s essential to know the information we’re going to tell you, but you’re far better if you have the answers to these questions. Alright, are you ready for the questions?
What would make this strategy viable?: Without a clear answer to this question, it’ll be super hard to know if the strategy is actually viable. Your bias will start taking over your rational thinking, and you’ll be much more likely to make a bad decision.
What would make this strategy impracticable?: Knowing the negative signs of a strategy is just as important as knowing the positive signs. When you know the negative signs a strategy includes, you’ll be able to make a much more rational decision.
Is the price worth it?: Any strategy isn’t worth a penny if you don’t put money into the equation. Without calculating the total amount of spending on a strategy, your chances of making a loss increase significantly. Therefore, calculate all the costs and consider them when choosing a strategy. You should consider the transaction fee, withdrawal fee, and the cost of the tool you’re using for getting your data (these tools can be quite expensive).
Since we’re talking about how crypto backtesting works, there is one thing you should know. Similar to analysis charts, crypto backtesting doesn’t give any guarantee. Even in cases where a strategy seems perfect by backtesting standards, there is absolutely no guarantee that things will work in your favor. However, this doesn’t mean you shouldn’t use crypto backtesting. Because it significantly improves your chances of earning profits.
Discretionary Vs Systematic Crypto Backtesting
There are two types of crypto backtesting. Discretionary (manual backtesting) and systematic backtesting (automated backtesting).
We’ll talk about how they work and their pros and cons. Are you pumped to talk about these two types? Awesome! We’re going to start with discretionary backtesting.
Do you want to become truly great at crypto backtesting? Then, discretionary backtesting is right for you. Discretionary trading means that you do the backtesting manually. This doesn’t mean you won’t use any tools. But, you’ll put in extra effort to become great at backtesting.
Here is how it works. You’ll need to use a tool that’ll manually simulate the strategy with fake assets, so you don’t risk real assets. There are lots of tools that provide this feature, but we recommend you use a good paper trading software. This is because paper trading software provides the most accurate data, so your chances of success will increase.
Now, let’s talk about how discretionary trading work. First, you should open the software and go to charts. Now, select your strategy, the price, and press replay. Candles will start appearing on your screen, and what you should do is note all the signals documenting the trades and then use this data to decide whether to buy or sell. Now, pick your option and try out your strategy. In case you succeed, you can go ahead and try your strategy in the live market. However, it’s still best if you could find some ways to improve your strategy even more. If you lose, then either modify the strategy or abandon it.
Now that you know how discretionary backtesting works, let’s talk about the pros and cons. First, we’ll look at the pros.
- Emotional Regulation: Because you have to do all the hard work manually, you experience a lot more emotions as well. Therefore, you have to spend much more time managing your emotions when you’re doing discretionary backtesting, thus you get better at regulating your emotions.
Since emotional regulation is a super important skill for all types of trading, you get to leave with a remarkable tool at hand by doing discretionary backtesting.
- Better Understanding of Strategy: By doing everything manually, you’ll get a great understanding of how the strategy works. This will help you make better decisions.
- Time Consuming: One of the biggest downsides of doing backtesting manually is that it’s too time-consuming. It takes hours to successfully backtest a strategy, which is literally over a dozen times longer than automatic backtesting. Now just imagine how you would feel if you have spent hours of effort into something, just to find out that it’s not worth it.
- Limited Data: Since you’re getting the data by putting in the manual effort, there is a pretty good chance that the data you end up with will be limited. This will definitely have a terrible impact on your strategy.
- Trading Costs Not Simulated: The last disadvantage of backtesting is that the trading costs are not simulated, so you’ll have to enter the estimates in your spreadsheet log. It’s not a big one, because finding out the costs won’t take too long.
- Risky: Since manual backtesting involves human bias, the data for the strategy is much more likely to be biased. This means your strategy will have a good amount of inaccurate data, which is risky.
In systematic backtesting, a lot of heavy work is taken off your plate. This is because you just have to choose the strategy, and not code it into the software. In other words, you don’t have to test the strategy against the historical data market. The software that provides this systematic backtesting will include a bot that’ll do the testing for you.
Let’s look at the pros and cons of systematic backtesting. Let’s start with the pros.
Low Risk: The data you get is more accurate. It’s free of human error and bias so your strategy will be low risk.
Less Effort: Since all the heavy work is done by bots, you don’t have to put much effort. You do have a choice to use your own input to make the strategy even better, but even in that case, you probably won’t have to do nearly as much work as doing everything manually.
Creating Algorithmic Strategy: Creating an algorithmic strategy is a skill. Therefore, if you’re a newbie, then you have to learn how to create algorithmic strategies first. It could take you weeks to understand how algorithmic strategies work.
As you can see, systematic backtesting is much better than manual backtesting. The only good benefit that you get from manual backtesting is you learn how to regulate your emotions. A great skill for a crypto trader, but it can be honed in other, less risky ways.
Types of Market Data
By market data, we mean the historical records you’ll use when doing backtesting. These historical records exist in different forms and we call these forms types of market data. With that clear, let’s talk about types of market data.
There are multiple types of market data you can use for backtesting a crypto asset. In this section, we’re going to talk about the two most common ones. Let’s look at their names and then we’ll discuss them in detail.
- OHLCV Candlestick Data
- Order Book Data
OHLCV Candlestick Data
You have probably heard about candlesticks, but you may not be familiar with OHLCV candlesticks. What does OHLCV mean? The first four letters represent a specific position’s price. Open price, high price, low price, and close price. The last letter in the name stands for volume, and it represents the volume for each price.
Now, let’s talk about how OHLCV candlesticks work. You enter the strategy, select the timeline, and the OHLC prices in the form of a spreadsheet.
The purpose of the timeline is to give you the OHLC prices for an asset using a specific strategy in a specific time interval. For example, you want the OHLC prices for ETH for a short time interval of 15 mins. You enter all these values in the candlestick and the data you get as output shows the OHLC prices for ETH in the specific 15 mins you selected.
While OHLCV candlestick charts provide good value, they include some big drawbacks as well. One of the big drawbacks is that you don’t get accurate trade volume for the prices. It’s not that the volume isn’t just accurate, but you also don’t know which volume represents which price. As you can see, the drawback is pretty huge. How are you supposed to create a great strategy with inaccurate and unclear data?
If OHLCV candlesticks are not great data providers, then why are they so popular? Because they are super easy to acquire. They are cheap, save a lot of time, and are not too complex to use.
Order Book Data
Order books are hands-down, one of the best sources for getting historical data. Compared to candlesticks, they provide a much larger variety of data and the data is more accurate as well.
What sort of data can you get using order books? Well, let’s have a look. You can get all four market prices, volume for each price, and depth. As you can see, the variety is huge. But wait, there is more. You can also use order book snapshots to simulate slippage, liquidity, and bid-ask spread. The variety of data you can get using order books is super amazing.
But, everything is not bloom and gloom about order books. It’s super difficult to acquire data using order books and the data might be super expensive.
Order book snapshots contain an enormous amount of data. How huge are we talking? Even the exchanges with the largest storage can’t afford to hold the entire history of order book data. Therefore, exchanges get rid of the huge amount of data from snapshots.
All hope is not lost. In case you can’t find the data you’re for from any exchange, you’re probably going to find it from a third-party service. But, there is a catch. Since this data is scarce, they are going to charge you a hefty amount for it.
Improve Your Trading
Regular backtesting is definitely one of the ways to improve your crypto trading, but if you want to maximize your results, you should also use a robust crypto scanner. It will give you the option to scan hundreds of metrics (such as price, volume, spikes) for thousands of coins from the most import crypto exchanges. With this tool you will never miss a trade again. You can try it for free here.