Backtesting is not blasting thirty to fifty trades on your backtesting software and claiming that you have a profitable trading system just because the account balance is on the positive side -- it's a more thorough process than that. In this article, you'll find out how to backtest forex strategies the right way. You'll also find, in the second part of this post, some misconceptions traders have about backtesting.
Here are six steps you can follow to do your strategy testing correctly:
1. Know the rules of your strategy
Before you begin backtesting, your strategy rules must be crystal clear with you.
Your entry, exit, and risk must be carefully defined. It helps if you write down your rules to avoid wavering decision-making.
It's not that your rules should be etched in stone and is unamenable to change, but you have to make sure that you'll make adjustments when you've proven, through substantial backtesting data, that your strategy is fatally flawed.
2. Ask yourself: Automate or Trade Manually?
Determine if you're going to be automating your strategy or if you're going to backtest manually.
Are you building an EA, or are you testing out a strategy that requires manual execution?
Why does this matter?
Well, an automated strategy will fire up trades as soon as it receives signals from its algorithm. It doesn't account for fundamental data or the condition of the market.
If you're testing a manual strategy, you know what its limitations are and where it's applicable.
But, if you're experimenting both automated and manual systems, be sure to distinguish which one is which before testing.
3. Set the duration or the number of trades
What time frame are you using? Are you backtesting with a daily chart or a five-minute chart?
Like what's stated earlier, you can't claim you're profitable after thirty or fifty trades. You have to put that into context.
What if your system trades the minute chart and it churns out a profit after closing thirty trades in a span of twenty-four hours? Obviously, there are the next few days that might tell a different story.
What if your system trades the daily chart and you're profitable for the first two months of 2014 after forty trades? What about the rest of the year, the next year or the year before? You can't have a shortage of data to underpin your claim -- it should be adequate in a relative sense.
4. Record results
Then, for each trade, record your results on a trading journal or a spreadsheet. When you backtest with a backtesting software, like Forex Tester, you can export your trading results to Excel. And the same goes for the strategy tester in MetaTrader with your backtesting results from an EA.
5. Analyze the statistics
Now, the beauty of exporting your results to Excel is that you can conduct plenty of analyses.
You can determine the profitability, the success rate, the average time to close a trade, drawdowns, average return, return on a specific period, etc.
Those stats aren't just there to provide you an idea of your strategies performance, but it supplies you with a basis of comparison in case you decide to make major or minor refinements to your strategy.
6. Be grounded with your expectations
Finally, once you deem your strategy is ready for real account trading, you have to remember to be grounded with your expectations.
It doesn't mean that if you managed to get a return of 30% from your backtesting session that it will yield the same results with a live account.
This brings us to the next section of this article, which is...
Misconceptions about Backtesting
1. You'll get the same results with a real account
This echoes what's mentioned above about being grounded with expectations.
Traders often think that just because a backtested strategy yielded a certain return on historical data that it's going to be the same with a real account. Nothing can be further from the truth.
The market, as you know, is very dynamic and is sensitive to a lot of influences.
So to say that an unchanging strategy will be profitable perpetually in an ever-changing market is somewhat contentious.
2. You'll win all the time
Backtesting is not synonymous to full proofing.
Traders often think backtesting as a way for them to make their system infallible, which is wrong. When you backtest a strategy, it should come with the expectation that some trades are still going to be losers, and that's why determining risk is crucial.
3. It helps you take out emotions in real trading
No, it doesn't.
Backtesting is mostly about understanding the performance of your trading strategy. As much as it can't guarantee the same performance prospectively, it can't take away your emotions when trading real money as well.
The cure for erratic trading behavior is experience. Think about it. When you have plenty of experience about something, whether a new job or an unfamiliar task, it becomes less and less daunting when you improve or get more experienced at it.
If you haven't traded with a real account before and most of what you've done so far is demo trading or backtesting, then you'll come to grips with different emotions with your real account trading sessions.
So, as you can see, testing your strategies on past price data requires diligence to get the most information. It's not a one-and-done thing, but it's a continuous process that aims to ensure that a trading system is viable.
Where To Go From Here
If you're interested in backtesting your trading strategy, you might want to check out our review for Forex Tester by clicking the button below.