What Is Backtesting

Backtesting in five lines

Backtesting is taking a rule you have written down and running it over bars that have already happened, to see what it would have done. It has four parts: the rule, the old bars, the costs of each trade, and the result written down trade by trade. It answers one question, what this rule would have done on those bars, and nothing more; it cannot promise the next bars, because the future is not in the file. The example in this paper is deliberately plain: buy the euro against the dollar at 10:00 on the feed's clock and sell at 18:00, every day of one week in August 2026. It lost 56.7 pips, where a pip is the fourth decimal place of the price, and that honest answer is the point of asking.

A tape of old bars, rewound

Picture a tape. Every bar since January is on it, and it does not change. A backtest rewinds the tape and plays the rule over it, reading the rule aloud at every bar, buy here, sell there, and writing down each result. The same tape can be played with a hundred different rules, which is what makes it useful and what makes it dangerous, because a rule can be bent until it fits one tape. What gets written down is what the rule would have done, not what you would have done watching the bars arrive live with money on them, and the two are not the same.

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