Like in any other business, experience is the key in order to be successful in forex trading. Developing a trading strategy over time, that will define the way how you approach trading, is just the first step in becoming a profitable trader.
Your trading strategy might not work the way you imagined, and it can turn out that the strategy is not profitable at all. To avoid learning this the hard way by losing your account, you have to backtest your trading strategy to get a picture of how it performs in various market conditions. This is where we come to the concept of backtesting…
Video: How to Backtest a Forex Strategy
Backtesting is simply putting your strategy at work with previous market data. Successful traders do this to see how reliable their strategy is, how profitable it is and how it behaves in different market conditions. A good period of time to perform the backtesting of your strategy would be the previous 10 or 15 years.
Performing a backtest on a shorter period may catch just one type of a market, such as a trending market, and if your strategy is a trend-following strategy it will return very good results in that case. However, if the market turns sideways, you may lose a big part of your trading account. That’s why you should do the backtesting at least 10 years back.
The Two Types of Backtesting
There are two ways to perform a backtest of your strategy:
- Automated backtesting
- Manual backtesting
Automated backtesting involves creating a program that automatically opens and closes trades for you. These programs, such as Expert Advisors (EA) on the Ultimate Charting Software platform, are usually based on a technical algorithm, and will open and manage the trades for you when certain technical conditions are met (for example, a Stochastics overbought/oversold crossover).
This way of trading involves creating, or buying the program itself, which can be either time consuming or expensive.
It also doesn’t add to your trading experience, and I don’t recommend this way if you’re serious in becoming a successful trader. You need to feel the market in order to become experienced. That’s why we will focus on manual backtesting in this article.
Manually Backtesting a Forex Strategy
Manual backtesting is when you manually scroll the chart on your trading platform to a previous period, and then manually go forward, bar by bar, with the “forward” arrow on your keyboard. Doesn’t sound exciting? Well, this the best way to see how your strategy will perform in various market conditions, and where it needs improvement.
There are four steps when manual backtesting a trading strategy.
Step 1: Open the chart of a currency pair on which you want to backtest your strategy, and scroll the chart to a previous period. On most trading platforms, you can simply drag & drop to change the date of the chart. Also make sure that all indicators and other tools that are part of your strategy are applied to the chart. In our example, we will use a simple moving average crossover strategy on a daily time frame.
Step 2: Move the chart bar by bar and spot possible trade setups.
Step 3: Now that you found a trade setup based on your trading strategy, you will need to write down the trading results of the imaginary trade that you’ve taken. You can do this with a simple Excel spreadsheet, where you enter the date, entry point, stop-loss, take-profit, reward-to-risk ratio or any other information you think might be of interest to you.
Step 4: In this step, you’ll repeat the process until you find a possible trade setup again, after which you go back to Step 3.
Manual backtesting can be time-consuming, but it’s the best way to feel how your trading strategy would work in various market conditions. If you backtest on a daily chart, 10 years’ worth of data has around 2500-3000 bars, and it’s perfectly possible to go through all of them in a few hours of work.
Don’t be afraid of the amount of data, as backtesting your strategy is the most important point before you start using your strategy in real trading.
Why You Need to Backtest Your Strategies
Backtesting is one of the most important points in the process of developing your trading strategy. It will reveal how your strategy will perform in various market conditions, and answer the most important question: is it profitable? However, have in mind that past results are not an indication of future performance.
Your backtesting might show that your strategy would work in the past, but the market changes all the time and a strategy that was once profitable, could become unprofitable in the future.