Good trading strategies must be based on sound logic or economics. This should be the base case for trade method ideas generation. Backtesting is then the only method to validate trade ideas generated. Backtesting is often misunderstood to be a tool to “discover” trading strategies by scanning a massive combinations of techniques or indicators. The base case for backtesting is actually to validate ideas to seek empirical evidences about a hypothesis (in this case to determine if a strategy is statistically deemed to be profitable beyond mere chance).

That said, data mining techniques to discover strategies is available however we need to be aware to discount data mined strategies’ results to account for a positive bias in data mined results. (This topic will be discussed separately in future.)

Backtesting is also to test how robust a strategy is. The strategy should work over different situations such as different price regimes, in a fairly similar or predictable fashion. Backtesting also gives us an indication of expectations, both in terms of risks and returns.