Backtesting as an Essential Forex Tool

If you are thinking about entering the Forex market, you should be conscious that this requires a fair amount of time investment and is a thorough process. As in many professional careers, the beginner trader has to go through a process of preparation and practice in order to succeed and Forex is not the exception. In this article we will examine Backtesting, which is an important part of the processes that all traders should realize.

Forex Backtesting

This is a procedure used by beginner and advanced traders, which consists of performing a series of exercises in order to validate strategies learned to trade the market. It is based on the comparison of estimations and results. In other words and in a more specific form, it consists of realizing historical tests of a particular strategy.

Using this, the trader is able to confirm the functioning and the effectiveness of a strategy or trading system. It is advisable to realize backtesting on an ample time span to gain confidence in our own trading method. During this process, statistics are generated on all the information gathered to obtain conclusions in the end.

The Importance of Backtesting

A person who is thinking about starting trading the Forex should perform backtesting, since this will help avoiding later losses. The backtesting must be performed by all traders, no matter if you are just beginning or if you already posess some experience. If you are a beginner, it is necessary that you form a habit from the most early stages, and if you have been trading for some time, this will help you to obtain better results if you haven’t developed the habit of doing tests.

This procedure is considered as very important, as it will reinforce:
• your confidence to trade
• your confidence and safety in employing a particular strategy
• your memory to realize further trades in the future.

Also, it will help you:
• To accelerate your learning of the trading process
• To develop effective skills to implement your strategy
• To confirm the effectiveness of a strategy

In general it is recommended to have performed at least approximately 300 tests of backtesting with different variables, before starting operations in the markets with real money and this way you will be better prepared later on to start trading your strategy in a real account. This way you will not lose your capital in a few trades.

Procedure to perform Backtesting

Before starting the backtesting, you have to make up your mind so to tolerate the mistakes that could occur, and assigning no importance to the amount of times that you will fail. Remember that the target when performing a backtesting is to do tests. It is better to fail in tests that to make mistakes in a real account.

There is no definite format or model to follow when doing a backtesting. This will depend on what the trader wants to validate, nevertheless we will explain some fundamental aspects needed to realize this procedure.

You can start taking a sample of 200 or 300 situations that happened on the market. This is called a "random test" since the contexts of the market are chosen at random. You must first establish the parameters and be objective in making decisions at the moment of implementing this procedure, because the less subjective it is, the better will the obtained results be.

After this, you should place your trades as if you were operating in real time and tabulate your results, using an Excel worksheet. You need to perform the backtesting on real circumstances to obtain better results, for example if you are accustomed to trade on 1 hour charts and with specific pairs, you should do the tests under the same context.

You can adjust the Excel worksheet so it fits to your own analyzing method. It is recommended that you specify the following in the cells:

• Pair used for the test;
• Open and Close prices;
• Strategy, which must specify the time frame and what indicators are being used;
• Profits made. It is recommended to order these from bigger to smaller.
• Losses made.
• Specify the amounts of the bigger winning trade as well as of the bigger losing trade.

This information can change, but these are the fundamental elements that the Excel worksheet should contain. At the moment of the analysis it is recommended to estimate a percentage of profitability of the strategy and a percentage of the maximum consecutive losses. Also, you will have to estimate the averages and standard deviations for your analysis. After this you can make graphs that will show your results in a clearer form.

Finally after having realized the backtesting, you must establish your own rules, based on the obtained results and you will make your own conclusions, as your next step will be to implement your tested or verified strategy on a real account. Doing this procedure will help you to choose the most suitable strategy to operate and to win consistently and continuously on the Forex market.