12 Back-Testing Advantages and Techniques in Forex

Back-testing via your forex demo account is the way to check whether your trading strategy is successful or not. The general idea behind back-testing is to find an effective strategy that worked well in the past and is most likely to produce the same winning results now.

Benefits

Backtesting strategy is used to test the technical analysis of various strategies to be applied in forex. By using backtesting a trader can test the workability of a given strategy and can thus check whether similar results would have been achieved as achieved in the past. Once you have the past results and results achieved after backtesting, you can compare and determine whether the strategy has predictive value or not. It is very common among technical traders and most of the trading is done on computers. The digitalization era has made the task easier and less complicated.

Backtesting trading strategies builds up the confidence among traders about the success of the designed strategy before implementing in the current market scenario. It is based on the notion that if a strategy has proven itself right in the past then it will work successfully in the future as well and vice versa. Nearly anything can be back tested, so backtesting has wide spread usage possibilities.

Back-Testing Strategy Advantages

1.     Recognition of the patterns that tend to repeat itself within a certain course of time.

2.     Deeper understanding of the trading system and more precise decision making during the draw-down period.

3.     Estimation of the potential profits and losses based on historical performance data.

Back-Testing Drawbacks

1.     Some strategies require a specific spread conditions, meaning that those strategies might not be as effective during live trading compared to demo.

2.     Summer and winter time changes may cause the confusion and mismatch price and history figures for specific charts.

3.     Trading live means dealing with volatile market prices. Strategies based on order for entries may not work very well in live trading, since the entry prices between demo and live account might differ.

Past data isn’t necessarily a good predictor of future market behaviour, so no strategy can guarantee accuracy

You may be tempted to refine a model so that it best fits historical data, without accounting for the fact that future conditions may be different

Past datasets may be skewed due to an adverse market event or uncharacteristically positive sentiment

Insufficient datasets will likely produce models that do not account for a wide variety of market conditions

A trading strategy that works well on several datasets from one market (eg forex) may not work well in another market (eg shares)

Strategies that tested well in a bullish market may not perform in a bearish environment, and vice versa

How to Use Back-Test Strategy in Trading?

1.     Download MetaTrader 4 platform and Expert Advisor from your forex broker.

2.     Open MetaTrader 4 platform and click on VIEW.

3.     Click on Stategy Tester – a new window will pop up.

4.     Choose the Expert Advisor you wish to test.

5.     Select the currency pairs (EUR/USD, USD/JPY etc).

6.     The field “Model” is the accuracy options. Using every tick is advisable.

7.     Check the date box and choose the period of testing – the beginning and the end date.

8.     Visual mode will show a chart with the actual trades. The disadvantage of the visual mode option is the significant delay in the back-testing process, therefore you might consider giving it up.

9.     Period drop down menu shows the time frame of the chart.

10.  At Expert Properties you can choose the initial deposit.

11.  At Expert Properties choose the Inputs options. You might want to start with default settings for now and change in needed with time.

12.  You are all done – click on start button and see your back- testing in action.

Automated Forex Backtesting

Automated forex Backtesting is gaining popularity, and many trading platforms offer well-designed trading wizards. You can also obtain forex backtesting software from third-party vendors. You can create a trading model by leveraging technical indicators to set your rules, and it saves you valuable time and helps you screen the historical data sets faster.

How to Backtest using MetaTrader

Another option is to learn how to backtest a trading strategy in MT4 (MetaTrader 4) or MT5 (MetaTrader 5), a popular trading and backtesting platform that can be downloaded for free from Admirals. This method is very popular among automated traders. Once they have programmed their trading system using an Expert Advisor or using a free one from the MetaTrader Market place, the MetaTrader trading platform will automatically find all of the previous trades that met the rules coded into the system and provide a historical and detailed report.

Summary

Backtesting is the act of applying a system or strategy to historical pricing data. In doing so, a statistical track record is created that reflects the past performance of the methodology. Such studies promote trader confidence and are useful tools in system building. However, backtesting has several pitfalls, including flawed data sets, confirmation bias and it doesn’t account for variable order execution.

Ultimately, backtesting is a good place to begin analysing a strategy or system. While certainly not perfect, the discipline can be valuable in spotting weaknesses, strengths and improving an existing methodology.

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