Basically, forex backtesting is something of a capital for every trader which relies on different indicators or algorithms. And as we all know, testing a forex trading model or strategy, or an expert advisor commonly known as a trading robot, can be time-consuming. And compared to advanced testing, backtesting provides a fairly high level of speed. But you must understand that between the two there is a correlation that is interdependent. At the beginning of its creation, namely in the 1980s, the design of forex backtesting was still very simple. Even data logging still uses the manual method in a special note. But this method tends to get lost and hard to find because everything is mixed up.
It is important that you understand that a good ability to read backtesting is an important thing that you need to understand. Because it is to increase the possibility of getting high profits. But before that, it would be easier if you understand the definition of backtesting first.
What does Forex backtesting mean?
When we talk about backtesting Forex trading strategies, we generally mean the use of historical data to predict how a given strategy will perform under the same market conditions. In other words, the concept considers the use of a set of fundamental rules; technical problems; historical price data, and analysis to see what results a particular strategy will produce within a given time frame.
Why is it important to know how to back-test Forex?
Such knowledge provides additional benefits to traders. The main advantages are:
- Concept overview: You have a complete overview of the strategy you are using. It is therefore possible to predict results and yields,
- Practical Skills: As you retest Forex trading strategies, you develop important technical analysis skills with the ability to identify the most profitable trading opportunities while tracking past price action.
- Trading Confidence: The more experience you gain, the more confident you can make each new transaction. This is very important before opening a live account and trading for real.
By taking all of these factors into consideration, newbie traders will have the perfect opportunity to make their strategy as successful as possible.
How does Forex backtesting work?
As you already know, this concept uses past price data to reconstruct trades taking into account current market conditions. Users can choose from a variety of retesting software. These can have different types and methodologies. Depending on the type of software, traders will benefit from a variety of technical indicators:
- ROE– the expected total return on equity,
- P/L– the total amount of profit and potential loss,
- Total Loss and Profit Ratio– it helps to identify the number of successful and failed trades,
- Volatility– helps to identify market and environmental conditions as well as downward and upward trends,
- Risk-adjusted returns– help calculate potential returns with reference to the risk of the strategy involved.
With the best backtesting, you will benefit from all the necessary market information and strategies that will allow you to assess potential performance
How to backtest a Forex trading strategy?
Indeed, traders will have a wide selection of different software to retest Forex strategies. Each type of software is equipped with a special evaluation methodology and algorithm. However, the two main categories, including demo accounts and manual tests, are returning.
Trade with a free demo account
It’s the easiest way to test any strategy, no matter how complex your preferred trading style is. The main advantage here is that you don’t have to risk your own funds. The broker will load your balance with virtual money so you can trade in real market conditions with full access to MT4, technical indicators, and other resources.
b. The manual retest
This option takes longer. In addition, it requires deeper financial knowledge and involvement. The process itself is quite simple. All you need is to generate historical price data and fit it to a specific chart pattern that examines each bar to identify price action within a specific time frame. The main advantages are:
- Suitable for beginners and professionals,
- Thorough understanding of how the Forex market and software work,
- The manual approach allows testing of actual trading conditions and mechanics and finding the best market entry and exit points,
- This is a good way to learn important skills in technical analysis. You will see how the software and the indicators work with your own eyes. It will develop good financial and trading skills, allowing you to grow from a beginner to a true Forex professional.
What are the disadvantages of Forex backtesting?
As with all things financial markets, there are notable downsides to backtesting historical data. At the top of the list are confirmation bias, bad data, and inconsistent trade execution.
Unreliable data
It is important to remember that forex is an over-the-counter (OTC) market. In turn, liquidity providers and brokers operate at single prices, although the differences are minimal. This may cause discrepancies in historical data, which may skew backtesting results.
b. Confirmation bias
When analyzing past events, humans are susceptible to a pitfall: confirmation bias. Confirmation bias can confuse any backtesting study, making results inaccurate and misleading.
According to the Cambridge Dictionary, confirmation bias is “the fact that people are more likely to accept or notice information if it seems to confirm what they already believe or expect”. This is particularly relevant for backtesting; because marketers often unknowingly adapt the data or parameters of the study to create positive results. In this case, the statistical track record is misleading and does not represent the true performance of a strategy or system.
vs. Execution
As anyone with significant trading experience can attest; Trading in the real market is very different from applying parameters to past forex data series. A multitude of factors come into play, including bid/ask spreads and slippage.
Slippage is the difference between the desired order price and the price at which the order was actually executed in the market. Backtesting cannot take this variable into account, therefore market entry and exit values may be inaccurate. Additionally, bid/ask spreads vary significantly as market conditions change in terms of liquidity and volatility.
Taken together, the bid/ask spread and the slippage variance are capable of significantly influencing backtesting results.
What is the advanced test?
The advanced test is the application of a strategy’s parameters to the course of the price action. Also known as paper trading, prospective testing involves applying a system or strategy consistently to real markets. Such projects can be conducted using a trading simulator linked to a demo account. There are many products designed for forward testing, such as Tradingview’s paper trading feature.
Forward and backtesting are often combined to create a comprehensive strategic analysis. For this purpose, traders select a backtest period and then perform a forward test in the real market. Once an appropriate set of samples has been created for forward testing, the results are compared to the backtesting study.
The effectiveness of the strategy is judged by examining the variance between the forward and backward data sets. If the results diverge, the system reflects random performance; if they are complementary, the system parameters are valid.
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Conclusion
Backtesting involves applying a system or strategy to historical price data. In this way, a statistical balance sheet is created that reflects the past performance of the methodology. Such studies build traders’ confidence and are useful tools for building systems. However, backtesting has several pitfalls, including incorrect data sets, confirmation bias, and ignoring variable order execution.
Finally, it should be remembered that backtesting is a good starting point for analyzing a strategy or a system. Although imperfect, this discipline can be invaluable in identifying weaknesses and strengths and in improving an existing methodology.
Notes: It is important to note that in addition to backtesting, advanced tests must also be carried out in the real market to validate the experiments carried out. And one thing that you should never forget, is that in order to get more profit, then make sure you master some knowledge as well as other tricks in the world of trading.
