Forex Backtesting: How To Evaluate A Forex Trading System
Just looking at the statistics on the number of successful forex traders, itis easy to know that Forex trading is not easy. The rewards are huge ifyou you are successful, but the risks are just as huge. One way that canhelp you get a great understanding of forex and help you be a successfultrader is to learn how to use forex backtesting to evaluate a forextrading system.
Before we get into the nuts and bolts of forex backtesting, it is a goodidea to look at some of the basic definitions of a forex system andbacktesting.
A forex system is a set of rules that tell you when to buy or sell a currency. Thiscould be based on a set of signals from technical analysis, charting tools, ornews based events. A system can be either manual or automated. A manualsystem involves a traders analysis, looking for signals to decide when to buy orsell. While on an automated system, the trader can use software to look forcertain signals and to interpret these signals.
There is really no right or wrong way here, it is more of a preference. However,many prefer an automated system as it leaves out the emotions that can leadmany traders to take bad decisions.
With a forex system, there are some strategies that the system will use togive trading signals. Forex backtesting is a way to test these strategiesand find out how well the system performed in the past.
This is done by using historical data, and to find out how that strategywould have worked if it had been used at that time. Backtesting doesntimply how a strategy would perform now or under future conditions.The markets do change over time and many factors can make thehypothetical performance and the actual performance differsignificantly.
So, while forex backtesting does not guarantee a profitable strategy, it isa huge step in the right direction. This is why many successful tradersare always backtesting their trading strategies.
There are two methods to use when doing forex backtesting. There isan automated backtesting where the trader can set the rules andcriteria of the strategy, and the software will automatically track thehistorical data and give a picture of how that strategy would haveperformed at that time.
The other method is manual. This would be done by going back intime on the chart and manually employ the trading strategies and see ifthey would have worked in a real-time environment. The biggestdisadvantage of the manual method is there is a lot of work involved.This makes it difficult to be sure that the backtesting is objective in themanual method.
There are two considerations that a trader must be aware of when doingforex backtesting. Both of these considerations will help you get betterresults in your forex backtesting. The first one is choosing the righttime frame. This is basically receiving enough trades to make the datastatistically valid. For example, if an account conducts 3 trades permonth, then it best to backtest several years to get enough data.
The second consideration is similar as the bigger the sample data thebetter the result. If you get a big sample data, the smaller the margin oferror and establish more reliable data. An example of this is to combine3 years of backtesting with 6 months of a forward test to develop a newtrading strategy.
Now you know to use forex backtesting to test your system and strategiesin trading and build a solid trading strategy. This can save you a lot oftime and money from using a trading strategy that is unrealistic orunprofitable.