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What Hedge Funds Really Do by Tucker Balch, Philip J. Romero

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CHAPTER 14

Back Testing Strategies

Once a hypothesis regarding a trading strategy has been developed, prudent investors will wish to test it before committing funds to its execution. The most persuasive approach would be to forward test—make simulated or “paper trades” for some period of time into the future to appraise the strategy’s performance versus a benchmark. But such forward testing takes time, unavoidably. An alternative is to simulate use of the tested strategy over some past period; this is back testing.

Back testing requires four main components:

Historical data to provide the context in which the strategy will be executed in simulation.

A definition of the strategy that can be automated.

A market simulator that represents ...

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