Forex Backtesting and Its Potential in Helping New Traders Succeed

September 21, 2018 Simon Hopes | Comments Off

Backtesting is a powerful tool that has helped a lot of traders succeed. It is particularly beneficial to new traders who are still in the learning process.

It is essential to note that similar to other forex trading methods; backtesting will not work for every trader or every trading system. However, it is something that can help take your trading to new levels.

What Is Backtesting

In the simplest of terms, backtesting is a process by which a trading strategy can be tested against historical data to see how well it would have performed. The idea is that if the strategy would have worked well in the past, then it will probably do so in the future.

Backtesting gives a trader a level of surety that the strategy will be profitable.

Types of Backtesting

There are two types of backtesting—automated and manual.

i) Automated Forex Backtesting

With automated backtesting, you either create or purchase a program that will enter and exit trades for you. Once you have the program or system, you can then test your trading strategy.

Similar to other automated systems such as those found on sec.rakuten.com.au, the benefits of automated backtesting include

  • The elimination of emotions from the process.
  • Lack of risk because the testing phase does not require money.
  • The ability to leverage the system on a copy trading service.

However, please note that automated forex backtesting has some considerable downsides as well. For instance, there is no guarantee the strategy will work in a live environment. That means you have to forward test it first.

In addition, you have to test the program extensively, you have to know the trading system’s exact parameters, and you have to understand coding or hire a programmer.

ii) Manual Forex Backtesting

With manual Forex backtesting, you execute each trade as an individual. The most significant advantage of manual backtesting is that it allows you to understand how a trading system works in full. That gives you a better chance of success when you move to live trading.

How Backtesting Helps Traders Succeed

Backtesting can help you succeed in one of two ways: It provides a platform for practicing, and it instills confidence.

i) Practice

Practice is crucial to the success of any trader. The more you practice, the sharper your skills. Backtesting allows you to test your trading strategy again and again. That means you are always practicing.

Additionally, backtesting simulates a live trading environment with the only difference being that you are using historical data and that there is no real money involved. That gives you further practice on how to handle live trading.

With enough practice, chances of success are higher.

ii) Confidence

Arguably, the most important benefit of backtesting. Whenever a well-conducted backtest yields positive results; it assures a trader that the strategy is sound and that will provide equally positive results in reality. More often than not, this is the case.

On the other hand, if the strategy yields negative results, then it gives the trader a chance to discard the strategy and come up with a better one.

Either way, backtesting gives a trader confidence that they are on the right track.

How to Ensure Backtesting Will Provide Meaningful Results

For one, a trader should not rely on the data used in backtesting to develop a strategy. If you do so, you will end up with a strategy that gives glowing results but does not work in a live trading environment. While it might seem obvious to avoid data used in backtesting, it is actually harder to do so than most traders think.

This is because most traders depend on historical data to develop their trading strategies.

Second, a trader should avoid data dredging. That is a situation where a trader tests a variety of strategies against the same data set. Similarly, this will produce glowing results that will not mirror the results achieved during live trading.

A trick that helps avoid data dredging is to use a strategy that works in a certain period then backtest that with data from a different period.