LessonsPsychology Articles

The Best Forex Back Testing Guide

If you’ve heard of Forex Back Testing but you’re unsure how to go about it. Then this guide is for you.

Just like in any other business, experience is the key in order to be a successful Forex Trader. Time spent Developing a trading system, that will define the way how you approach trading, is just the first step in becoming a profitable trader as it will be giving you that much needed experience.  Your trading system might not work the way you imagined, and it can turn out that the system is not profitable at all. To avoid learning this the hard way by losing your account, you will have to back test your trading system to get a picture of how it may perform in various market conditions.

This however is not the only reason to back test.  As it is still the most commonly attributed task to people becoming  successful traders.  If you ever want to be a successful trader, you really gotta get down and dirty in the trenches and do your fair share of back testing…

 

The Psychology and The Mindset

The more blogs you read and the interviews you listen to, the more successful traders are talking about how working on their psychology improved their performance as traders.  And let’s be clear from the start the key to success starts in your mind no matter what you want to be successful at.  Without the correct psychology, the right mindset, you won’t succeed at anything…

You might get enough to get by if you work hard, but you’ll never really be that success you’ve always dreamed about.

The difference between wanting to be a success in a business, writing, employment and most other forms of income generating tasks and trading is this. With a poor mindset you can be alright in almost any other environment, you won’t be a major success, but you’ll be part of the crowd that earns enough to get by with the help of a little debt.

The problem with the trading crowd you’ll be a member of is that they don’t earn enough to get by, in fact most of them are still losing money let alone making enough to cover the bills.

So, in my honest opinion anything that helps improve your trading mindset is a must do.  Not an “if I have time”, “maybe tomorrow”.  And that my friends is back testing.

 

How Can Forex Back Testing Help Me?

When you back test a system, you get to know it inside out.  You learn it’s different stages you get to know when to back off a bit or when to start adding in positions. You’ll know when it’s stopped working before you’ve lost all you funds.  You get to know the feel of the market you see how it moves and how it behaves.

This then gives you the ability to be disciplined… because you trust your system. You know it’s flaws (drawdown) and it’s gems (estimated rate of return). You can easily overrule any emotion-based decisions coming out of your non-trader side. Now because you are disciplined you are patient which leads to patience because you see in your account balance…growth and prosperity. You can now easily wait for your proper entry signal, rather than jumping in, in case you miss something.

With patience and discipline comes consistency… this is trading at it’s finest.  Completely boring if done correctly but highly profitable. Consistently taking the same set-ups time and time again.  No deviations, no wonderings, no what if’s or maybe if I’s.  Just doing the same thing day in day out when it comes to your trading. That’s consistency, that’s profitable trading.

And that gives you the ability to trade with just the right amount of confidence.

Now you know it’s importance let’s get stuck into the what and how…

 

What is Back Testing?

Back testing is the process of testing a trading system on historical data, to see how it would have performed in the past. In theory, if a system worked well in the past, it will continue to do so in the future.

Of course, market conditions can change, but we will get into that in the section on the limitations of back testing.  For now, just think of it as a way to have a reasonable level of certainty that a trading system will be profitable into the future.

Back Testing over a long period of time allows you to see how the system performs during different market conditions. If you only test in one type of market, you will get a very skewed look at the performance of the system.  For example, if you test a trend following system in a trending market, then of course it will do well! But if you also test it in a choppy market, then you get a much better idea of how much money it will lose.

Makes sense, right?

 

Practice

Just like a professional basketball player practices simple things like free throws, a professional trader also has to practice routine parts of their game.  That means practicing spotting opportunities. Back testing can give you that practice, even when the markets are closed.  You may think that this is not necessary, but if you don’t keep your skills sharp, it can be easy to enter a trade that doesn’t meet your criteria.  Especially if you trade multiple systems or markets.

When back testing you get to practice all of your skills, like drawing trend lines.  I know that sounds simple, but you may find that not cutting through any candles is better for you, or maybe you just look for the most touches.  Back testing helps you to see what works best for you and your system. It also helps with drawing your support and resistance lines or areas you can see for yourself of you are drawing them in the correct place.

You might spot set-ups or candlestick formations.  This will all help in your journey to grow as a trader…

 

Curve Fitting

Before we go any further, let’s define a very important term associated with back testing and that is curve fitting. This is when you back test a system over a short period of time and over-optimize it for that time period.  You will get very excited and believe you have invented the next sliced bread or apple iPhone because, that system will look great on paper, but will perform terribly in real trading.

To illustrate this point, let’s take a look at a historical chart of the EURUSD monthly chart. If you created a trading system by only using the data in the green box, then you would have undoubtedly created a trend following system.

back test curve fit

This trend following system would have been wildly profitable…during this time period.

 

But if you tested the same trend following system during the time period in the blue box, you probably would have been battered and bruised.  A regression to the mean or counter trend trading system probably would have worked better there. It’s not always that easy just to say I’m going to only trade in trending markets.

So, you tend to need a robust trading system.  So that it can make money and be profitable in all market conditions.

 

Two Types of Back Testing

There are two ways to Back Test

  1. Automated which doesn’t help your psychology, or give you practice, or give you any of the good stuff mentioned above. So, as you may have guessed, I don’t advise it.
  2. Manual Back Testing… Now we’re talking. More work for yourself but all the benefits. Remember trading is not a get rich quick scheme, in order to get the rewards, you have got to put the work in. If you don’t like the sound of that. Do yourself a favor and quit now. I’ve heard Uber are hiring…

 

Manually Back Testing a Forex Strategy

Manual back testing is when you manually scroll the chart on your trading platform to a previous period, and then manually go forward, bar by bar, with the f12 button on your keyboard. Doesn’t sound exciting? Well, this the best way to see how your system will perform in various market conditions, and where it needs improvement.

There are four steps when manual back testing a trading strategy.

 

Step 1:

Open the chart of a currency pair on which you want to back test your system and scroll the chart to a previous period in time. On most trading platforms, you can simply drag & drop to change the date of the chart. Also make sure that all indicators and other tools that are part of your strategy are applied to the chart. In our example, we will use a simple moving average crossover strategy on a daily time frame.

back testing trend system

Forex Trading Back Testing

 

Step 2:

Move the chart bar by bar and spot when the yellow ema crosses the red ema, this is the entry signal.

back testing two trade results

See how we’ve gone back to 2016. And got our first entry. All we do now is keep pressing f12 until the yellow ema crosses back over the red ema as this is our exit signal. And then we fill in the spreadsheet. Remembering that this is also your next entry…

Step 3:

Now that you found a trade setup based on your trading strategy, you will need to write down the trading results of the imaginary trade that you’ve taken. You can do this with a simple Excel spreadsheet, where you enter the date, entry point, stop-loss, take-profit, reward-to-risk ratio or any other information you think might be of interest to you. I use purple line for entry and a red line for SL. I enter details into a journal the same as I would a real trade.

back testing with results

 

Step 4:

Keep repeating this until you run out of chart.

Manual back testing can be time-consuming, but it’s the best way to feel how your trading system would work in various market conditions. If you back test on a daily chart, 10 years’ worth of data has around 2500-3000 bars, and it’s perfectly possible to go through all of them in a few hours of work.

Don’t be afraid of the amount of data, as back testing your system is the most important point before you start using your system with real money in live market conditions.

Why You Must to Back Test Your Strategies

Back testing is one of the most important points in the process of developing your trading strategy. It will reveal how your strategy will perform in various market conditions, and answer the most important question: is it profitable? However, have in mind that past results are not an indication of future performance.

Your back testing might show that your strategy would work in the past, but the market changes all the time and a strategy that was once profitable, could become unprofitable in the future.

That is how to get started with Forex back testing. I hope that I have cleared up any confusion that you may have had. If you want to learn the entire process, from beginning to end, come join The Forex Trader Accelerator Program. Contact me for details directly callum@specialfxacademy.com

Test often and you should start to see the benefits.

 

I firmly believe that the only habits you will stick to, are the ones that are easy to do. So, make back testing as easy as possible and it is a habit that you will keep doing.

 


Buy a subscription to any of our Trading Services, the FX CopyTrader, the FX Trading Room, or our FX Signals, and get the other two for free! No coupons needed. You'll be subscribed to all 3 automatically no matter which one you purchase!
The following two tabs change content below.

Callum McLean

Co-Founder and Trading Psychologist at Special FX Academy
Trading Psychology Coach and Certified NLP Coach. It is my belief that trading is 99% Psychological. And it is by understanding and improving your psychology, that you can be a successful trader. Success is a formula that everyone can and should learn.
Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments