Backtest Expert#

Systematic approach to backtesting trading strategies based on professional methodology that prioritizes robustness over optimistic results.

Core Philosophy#

Goal: Find strategies that "break the least", not strategies that "profit the most" on paper.

Principle: Add friction, stress test assumptions, and see what survives. If a strategy holds up under pessimistic conditions, it's more likely to work in live trading.

When to Use This Skill#

Use this skill when:

• Developing or validating systematic trading strategies
• Evaluating whether a trading idea is robust enough for live implementation
• Troubleshooting why a backtest might be misleading
• Learning proper backtesting methodology
• Avoiding common pitfalls (curve-fitting, look-ahead bias, survivorship bias)
• Assessing parameter sensitivity and regime dependence
• Setting realistic expectations for slippage and execution costs

Backtesting Workflow#

1. State the Hypothesis#

Define the edge in one sentence.

Example: "Stocks that gap up >3% on earnings and pull back to previous day's close within first hour provide mean-reversion opportunity."

If you can't articulate the edge clearly, don't proceed to testing.

2. Codify Rules with Zero Discretion#

Define with complete specificity:

• Entry: Exact conditions, timing, price type
• Exit: Stop loss, profit target, time-based exit
• Position sizing: Fixed $$, % of portfolio, volatility-adjusted
• Filters: Market cap, volume, sector, volatility conditions
• Universe: What instruments are eligible

Critical: No subjective judgment allowed. Every decision must be rule-based and unambiguous.

3. Run Initial Backtest#

Test over:

• Minimum 5 years (preferably 10+)
• Multiple market regimes (bull, bear, high/low volatility)
• Realistic costs: Commissions + conservative slippage

Examine initial results for basic viability. If fundamentally broken, iterate on hypothesis.

4. Stress Test the Strategy#

This is where 80% of testing time should be spent.

Parameter sensitivity:

• Test stop loss at 50%, 75%, 100%, 125%, 150% of baseline
• Test profit target at 80%, 90%, 100%, 110%, 120% of baseline
• Vary entry/exit timing by ±15-30 minutes
• Look for "plateaus" of stable performance, not narrow spikes

Execution friction:

• Increase slippage to 1.5-2x typical estimates
• Model worst-case fills (buy at ask+1 tick, sell at bid-1 tick)
• Add realistic order rejection scenarios
• Test with pessimistic commission structures

Time robustness:

• Analyze year-by-year performance
• Require positive expectancy in majority of years
• Ensure strategy doesn't rely on 1-2 exceptional periods
• Test in different market regimes separately

Sample size:

• Absolute minimum: 30 trades
• Preferred: 100+ trades
• High confidence: 200+ trades

5. Out-of-Sample Validation#

Walk-forward analysis:

1. Optimize on training period (e.g., Year 1-3)
2. Test on validation period (Year 4)
3. Roll forward and repeat
4. Compare in-sample vs out-of-sample performance

Warning signs:

• Out-of-sample <50% of in-sample performance
• Need frequent parameter re-optimization
• Parameters change dramatically between periods

6. Evaluate Results#

Questions to answer:

• Does edge survive pessimistic assumptions?
• Is performance stable across parameter variations?
• Does strategy work in multiple market regimes?
• Is sample size sufficient for statistical confidence?
• Are results realistic, not "too good to be true"?

Decision criteria:

• ✅ Deploy: Survives all stress tests with acceptable performance
• 🔄 Refine: Core logic sound but needs parameter adjustment
• ❌ Abandon: Fails stress tests or relies on fragile assumptions

Key Testing Principles#

Punish the Strategy#

Add friction everywhere:

• Commissions higher than reality
• Slippage 1.5-2x typical
• Worst-case fills
• Order rejections
• Partial fills

Rationale: Strategies that survive pessimistic assumptions often outperform in live trading.

Seek Plateaus, Not Peaks#

Look for parameter ranges where performance is stable, not optimal values that create performance spikes.

Good: Strategy profitable with stop loss anywhere from 1.5% to 3.0% Bad: Strategy only works with stop loss at exactly 2.13%

Stable performance indicates genuine edge; narrow optima suggest curve-fitting.

Test All Cases, Not Cherry-Picked Examples#

Wrong approach: Study hand-picked "market leaders" that worked Right approach: Test every stock that met criteria, including those that failed

Selective examples create survivorship bias and overestimate strategy quality.

Separate Idea Generation from Validation#

Intuition: Useful for generating hypotheses Validation: Must be purely data-driven

Never let attachment to an idea influence interpretation of test results.

Common Failure Patterns#

Recognize these patterns early to save time:

1. Parameter sensitivity: Only works with exact parameter values
2. Regime-specific: Great in some years, terrible in others
3. Slippage sensitivity: Unprofitable when realistic costs added
4. Small sample: Too few trades for statistical confidence
5. Look-ahead bias: "Too good to be true" results
6. Over-optimization: Many parameters, poor out-of-sample results

See references/failed_tests.md for detailed examples and diagnostic framework.

Available Reference Documentation#

Methodology Reference#

File: references/methodology.md

When to read: For detailed guidance on specific testing techniques.

Contents:

• Stress testing methods
• Parameter sensitivity analysis
• Slippage and friction modeling
• Sample size requirements
• Market regime classification
• Common biases and pitfalls (survivorship, look-ahead, curve-fitting, etc.)

Failed Tests Reference#

File: references/failed_tests.md

When to read: When strategy fails tests, or learning from past mistakes.

Contents:

• Why failures are valuable
• Common failure patterns with examples
• Case study documentation framework
• Red flags checklist for evaluating backtests

Critical Reminders#

Time allocation: Spend 20% generating ideas, 80% trying to break them.

Context-free requirement: If strategy requires "perfect context" to work, it's not robust enough for systematic trading.

Red flag: If backtest results look too good (>90% win rate, minimal drawdowns, perfect timing), audit carefully for look-ahead bias or data issues.

Tool limitations: Understand your backtesting platform's quirks (interpolation methods, handling of low liquidity, data alignment issues).

Statistical significance: Small edges require large sample sizes to prove. 5% edge per trade needs 100+ trades to distinguish from luck.

Discretionary vs Systematic Differences#

This skill focuses on systematic/quantitative backtesting where:

• All rules are codified in advance
• No discretion or "feel" in execution
• Testing happens on all historical examples, not cherry-picked cases
• Context (news, macro) is deliberately stripped out

Discretionary traders study differently—this skill may not apply to setups requiring subjective judgment.