Backtesting Crypto Trading Strategies: In-Depth Guide
Backtesting crypto trading strategies means testing your strategy with historical data to see how well it would have worked in the past to predict future success. It helps traders understand if their strategy is likely to make money in real trading.
In this guide, we will cover what and exactly how to backtest, common pitfalls to avoid, and the best tools to use, basically, everything you need to know about backtesting crypto trading strategies in one place.
What is Backtesting?
Backtesting is like a test drive for trading strategies. It started in finance as a way for investors to test their strategies using past data. Basically, it’s a method to see how well a trading plan would have worked in the past.
Backtesting in crypto trading strategies serves the same purpose. Traders use it to see if their strategies would have made or lost money based on historical cryptocurrency prices. It’s like practicing a game before playing for real. Backtesting helps traders learn what works and what doesn’t without risking real money.
It’s a valuable tool for refining trading approaches and making more informed decisions in a market as volatile as crypto.
Benefits of Backtesting in Crypto Trading Strategies
Backtesting is a valuable tool for crypto traders to learn, improve, and trade smarter. Why?
Here’s why –
- No-Risk Practice: Backtesting allows traders to experiment with various strategies without risking real money. It lets traders test their ideas in a safe environment before using them in live markets.
- Improving Strategies: By analyzing past data, traders can refine their strategies for better performance. For example, they can spot patterns in price movements and tweak their strategies accordingly.
- Understanding Market Trends: Backtesting reveals how strategies perform in different market situations, such as bull or bear markets, high volatility, or low trading volumes. This helps traders predict market trends and adjust their strategies to match.
- Boosting Confidence: Successful backtests build confidence in traders and give the traders assurance to trade confidently in live markets.
Key Components of Backtesting in Crypto Trading Strategies
From what we have described so far, backtesting may seem like a straightforward way to see how your strategies would have worked in the past to predict future success. But it’s not as simple as it looks. The following are some of the key components of backtesting in crypto trading strategies that you must learn to backtest effectively.
Historical Data
Historical data forms the backbone of backtesting in crypto trading. It includes past prices, trading volumes, and market conditions. Traders can source this data directly from crypto exchanges like Binance or Coinbase or through dedicated data providers such as CoinAPI and CryptoCompare. Accurate historical data are crucial for realistic simulations, but not all data sources are of the same quality. This makes choosing between free and paid data sources critical.
Trading Strategy Formulation
Creating a trading strategy involves setting clear rules for when to buy, sell, and how often to trade. Clarity and precision are key to avoiding mistakes and biases. By laying out these rules upfront, traders can fine-tune their backtesting and accurately test strategies.
Risk Management
Managing risk is vital for successful trading and effective backtesting. Understanding the potential drawdowns, or the peak-to-trough decline during a specific recorded period of an investment, is crucial. It helps traders gauge the risk involved in their strategies. Similarly, setting risk-to-reward ratios and proper stop-loss orders can help in realistic testing and limit potential losses in live markets. Additionally, how you allocate your capital can also affect the realism of your testing, as diversification and risk tolerance matter a lot in real trading conditions.
Check out our beginner’s guide to technical analysis if you don’t know what these terms mean.
How to Backtest Crypto Trading Strategies
Now we know what backtesting is and its key components. What’s next? Learning how to backtest. But before we go into the step-by-step guide to backtesting crypto trading strategies, it’s important to discuss the difference between manual and automated backtesting.
Manual Backtesting
In manual backtesting, traders take a hands-on approach.
First, they gather historical price data for the cryptocurrency they’re interested in. Then, they define their trading strategy, specifying when to enter and exit trades and how to manage money. Next, they apply the strategy to the historical data, recording each trade’s entry and exit points. Finally, they manually calculate performance metrics like total return, maximum drawdown, the Sharpie ratio, etc (more on these later).
While manual backtesting gets the job done, it’s time-consuming and prone to human error. However, it’s a valuable skill to have and has a low barrier to entry in terms of costs.
Automated Backtesting
Automated tools such as TradingView and Cryptohopper make backtesting easier and scalable.
Firstly, these tools fetch historical data from different markets and time frames without manual effort. Traders then input their strategy using specific languages (like Pine Script for TradingView). But with tools like ChatGPT, coding knowledge isn’t necessary. The platform then tests the strategy against historical data, recording trades, and their outcomes, and automatically generates reports with all the key metrics you need.
Overall, automated tools save time, reduce errors, and allow the testing of multiple strategies at scale.
Best Tools to Automate Backtesting Crypto Trading Strategies
There are many tools that allow you to backtest trading strategies, and not all of them are the same. Some are free, while others are paid. The features and functionalities offered by these platforms may differ. That is why choosing the one that suits your goals, needs, and budgets is crucial. Before we share our top picks to automate backtesting, let’s look at some factors you might want to consider to get more clarity on what to look for.
Ease of Use: Whether you prefer a graphical interface or are comfortable writing code.
Data Availability: The quality and range of historical data available, as well as the costs for accessing it.
Customization: The ability to adjust and fine-tune strategies to match your trading style and goals.
Cost: While some platforms offer free features, more advanced tools and data may require a subscription.
For most traders, using multiple tools might be the best approach, as each tool offers unique benefits that can complement one another depending on your backtesting needs.
That being said, here are the most popular tools to backtest crypto trading strategies out there:
TradingView:
TradingView is well-known for its advanced charting tools and social networking features. It lets you test strategies using historical data with a built-in tester. You can use various indicators and a custom scripting language called Pine Script to create and share your studies and signals.
Tradewell:
Tradewell is a new player in the market offering trading and backtesting tools for both beginners and experts. It provides strong analytics to visualize backtest results and optimize strategies. Its user-friendly tools suit traders of all levels and support both backtesting and live trading. However, being new, it may lack some integrations and community support.
Cryptohopper:
Cryptohopper is a platform focused on crypto trading bots but also offers robust backtesting. It lets you test strategies against historical data using a simple interface. Cryptohopper supports algorithmic strategies and can connect with multiple exchanges.
Step-by-Step Guide to Backtesting Your Crypto Trading Strategy
The following is a quick step-by-step guide to backtest your crypto trading strategies:
Step 1: Define Your Strategy
First, create a clear plan for your trading. Decide when you’ll buy and sell, which assets you’ll trade, and which indicators you’ll use. You might also set rules for trade size, leverage, and how often you’ll trade. Having a solid plan makes your backtest reliable and easy to analyze.
Step 2: Get Your Data Ready
Next, gather historical data that matches your strategy needs. This data should cover the time periods and assets your strategy will focus on. Make sure to use different datasets to utilize out-of-sample testing and avoid tweaking your strategy too much to fit the data. Get data from reliable sources showing prices, highs and lows, and trade volumes. Clean up the data by removing errors or missing parts to ensure accurate results.
Step 3: Run Your Backtest
Now, it’s time to backtest your crypto trading strategy. Use tools like Tradewell or Cryptohopper to apply your rules to the historical data. Input your strategy details and load your prepared data into the tool. The software will then simulate trading, making buys and sells based on your plan.
Step 4: Analyze the Results
Now, it’s time to review the results. Look at key metrics like profitability, risk-to-reward ratios, which include the Sharpe ratio, Sortino ratio, and maximum drawdown, and how consistent your strategy was in making profits or losses. Also, consider how your strategy performed under different market conditions.
This analysis will help you decide if your strategy is ready for real-world trading or if it needs more work to meet your goals and risk tolerance.
Common Pitfalls When Backtesting Crypto Trading Strategies
Despite following all the best practices for backtesting your crypto trading strategies, traders, even the experienced ones, often fall into one or more than one of these pitfalls.
Here is how you can avoid them –
Overfitting: Overfitting happens when a trading plan works great with historical data but flops in real markets. This occurs when a strategy is too tailored to past data and its quirks rather than tailoring it to broader underlying market trends and principles. Traders can avoid overfitting by testing their strategy with various time periods and market situations.
Underestimating Transaction Costs: Transaction costs, like fees, spreads, and commissions, can eat up profits. These costs vary between exchanges and market conditions, but it’s crucial to include them when backtesting crypto trading strategies to see if they’re really profitable. Ignoring these costs can make a strategy seem better than it actually is.
Ignoring Live Market Factors: Ignoring real-time market factors, like slippage and market impact, during testing can give false hope. To make your backtests more accurate, use slippage models and historical market depth data. Moreover, simulate gradual order execution and conduct sensitivity analysis in your tests. These adjustments help make strategies stronger and more reliable when used in real markets.
Refining Strategies Based on Backtest Results
The entire point of backtesting crypto trading strategies is to use the results to tweak and refine your approach. So, it only makes sense if we show you how to do that, too.
Iterating on Strategy
Analyze Results: Start by carefully analyzing backtest results. Refer to the last step of the step-by-step backtesting guide for what metrics to look for. Additionally, identify when the strategy is underperforming and try to understand why.
Adjust Parameters: Use the insights from the previous step to tweak strategy parameters. This could involve changing entry and exit criteria, adjusting stop-loss levels, or modifying indicators. The aim is to improve performance while balancing risk and return.
Re-test: After making adjustments, re-run the backtest to see how they affect performance. Repeat this process until you come up with a strategy that suits different market conditions.
Check Robustness: We’ve already mentioned this once as one of the common backtesting pitfalls, but test the strategy across various time periods and market environments to ensure it’s not overly tailored to specific conditions.
When to Revise or Abandon a Strategy
Knowing when to revise or abandon a strategy is also important:
Consistent Underperformance: If a strategy consistently performs poorly, it might need big changes or to be dropped. Check if the strategy’s core idea still fits the current market.
Market Changes: As markets change, strategies might stop working. Be ready to tweak strategies to fit new conditions.
Complexity vs. Performance: Sometimes, strategies become too complex through the iterative process. Simplify or rethink them if they’re too hard to manage without clear benefits.
Risk Management: Don’t stick with strategies that expose you to unreasonable levels of risk. Manage risk wisely based on what you’re comfortable with and how much money you have.
FAQ
How to backtest a crypto trading strategy?
To backtest a crypto trading strategy, follow these steps:
- Plan Your Strategy: Decide how you’ll trade, when to buy or sell, and how much risk you’re willing to take.
- Get Historical Data: Collect past price data for the cryptocurrency you want to trade.
- Use a Backtesting Platform: Choose a tool to test your strategy. There are many options available online.
- Set Up Your Strategy: Input your rules into the strategy parameters.
- Run the Test: Let the tool simulate trading based on your strategy and past data.
- Check the Results: Look at how well your strategy did. Did it make money? Did it handle risk well?
- Make Adjustments: If needed, change your strategy based on the results. Keep testing until you’re happy with it.
What is the best trading strategy for crypto?
There isn’t a single “best” trading strategy for crypto because it depends on different things, like how much risk you’re okay with and how much time you have. But here are the most popular ones:
- Following Trends: This means buying when the price is going up and selling when it’s going down. People use things like moving averages to see which way the price is moving.
- Swing Trading: This is about buying when the price hits a low point and selling when it hits a high point, trying to catch the ups and downs in the market.
- Day Trading: Day traders buy and sell crypto all in one day, trying to make money from small changes in prices.
- Scalping: Scalpers make tiny profits from lots of trades throughout the day by jumping in and out of the market quickly.
- Mean Reversion: This is about buying when prices are low and selling when they’re high, expecting them to go back to an average level. They use things like RSI or Bollinger Bands to figure out when prices are too high or too low.
The best strategy for you depends on what you want to achieve, how much risk you’re comfortable with, and how much time you can spend trading. Check out our in-depth guide on the best crypto trading strategy, where we break down each of them to help you decide what suits you best.
Is backtesting free on TradingView?
Backtesting on TradingView isn’t totally free. While you can do basic backtesting without paying, some of the fancier features need a subscription. Also, you might have to pay for certain tools and indicators used in backtesting. Just check out their pricing page to see what you get with each one.
Is crypto trading taxable?
Yes, when you trade cryptocurrencies like Bitcoin or Ethereum, you usually have to pay taxes on any money you make. Just like with regular income, you need to report your crypto trading profits to the government. Tax rules can vary from place to place.
Check your country’s tax rules to make sure you’re following the right rules.