Binary options trading has become one of the financial traders’ most popular investment options in the last five years. Its popularity has grown among beginner traders because of the simplicity of trading it and its potential for high returns. Traders can earn high returns in a short amount of time by predicting the price of an underlying asset within a timeframe.
It is a Yes/No kind of stake where traders must predict whether the asset’s price will rise or fall within a specific timeframe. A correct prediction is a win for traders to receive a payout on their investment. However, a wrong prediction will cause them to lose their investment.
However, the high probability of binary options traders losing all their investments has made it necessary for them to take risk management measures. Traders need an effective and reliable trading strategy to succeed in binary options trading. One such trading strategy is known as backtesting.
Have you ever learned a trading strategy and found it ineffective for you after a while? However, it’s such a popular strategy many people swear by it. Have you tried many trading strategies, but they all seem to fail and erode your investment?
If you have encountered these problems, the nagging question becomes, “How can I validate this trading strategy without losing money?”. This is the point where backtesting becomes useful.
Backtesting is assessing a trading strategy using data on historical prices. Traders engage in backtesting to identify the most profitable strategies and modify their current trading strategies. An effective backtesting procedure will give the trader confidence in the strength of the trading strategy.
Tools and Techniques for Backtesting
There are several tools and techniques used by binary options traders to backtest. However, the following are the most popular tools and techniques for backtesting:
- Historical prices data: Using historical prices data is one of the most common techniques to backtest. It helps traders to backtest their trading strategy using real market prices and conditions.
- Trading simulators: These software programs allow binary options traders to simulate trading based on data from historical prices. Traders can use this to backtest their trading strategies without risking real money.
- Spreadsheet programs: Spreadsheet programs like Microsoft Excel, Google Docs, etc., are very effective for backtesting trading strategies. This spreadsheet software can organize historical price data and properly generate trading signals.
- Automated trading platforms: Like spreadsheet programs, these are also software programs. However, these programs use algorithms to automate trading strategies. The algorithms execute trades based on specified rules and trade indicators.
How to build and test your binary options strategy by backtesting
Having established what backtesting is, let’s look at a few steps to understand the backtesting process.
- Define the trading strategy: The trader must define the strategy for the trade. You can learn from the Best Binary Options Strategies for Beginners. Your trading strategy should also include entry and exit levels, stop loss, take profit levels, etc.
- Gather historical data: Historical data is the most important thing in this process. Data must be gathered for the underlying asset covering the period the strategy will be tested.
- Apply the strategy to the historical data: To illustrate, assume you want to trade a currency pair based on moving average technical analysis. That is, to buy a binary option when the 5-period MA crosses above the 20-period MA and to sell when the 5-period MA crosses below the 20-period MA. You would:
- Use the data gathered to calculate 5-period and 20-period MAs based on price data.
- Identify the points where the 5-period MA crossed above or below the 20-period MA. These points are your trading signals.
- Check for the outcome of these trades, whether the asset prices went up or down.
- Evaluate your outcome: Calculate performance metrics such as profitability ratio, and win/loss ratio, and check for the downsides of the strategy based on the trade outcomes. Determine whether it was a good strategy or not.
Trying out new trading strategies without testing them can be very risky. You risk losing a lot of money or your entire investment by doing so. Backtesting provides a simple and risk-free way to test your trade strategies.