Sometimes, you will come up with what you think is the holy grail of trading strategies, only to apply it to the live market, and it fails more often than it succeeds. It is necessary to perform a backtest to ensure that the strategy works before investing capital in it. This can be done either manually or automatically using the software.
What is a backtest?
Backtest is a study that is carried out on a forex trading strategy to see how effective it may have been in the past. A strategy that passes this test has a high chance of yielding profits once it is applied to real-time trading.
You will need a thorough trading strategy before you can begin a backtest. At the very least, this strategy should outline the trade entry and exit points, the maximum amount of risk per trade, the preferred timeframe, and the positions of your stop-losses and take profit orders. A good strategy will also identify the ideal session for trading and any other conditions that must be met before a trading opportunity is deemed valid.
When doing this test, you can tweak your parameters at will until you find those that work best with your strategy.
Why perform a backtest?
- Backtesting will assist you in acquiring insight into the profit potential of your approach, especially when done over a long time. This test’s positive findings will increase your trust in the strategy.
- When your plan delivers poor results, this testing allows you to adjust your parameters. This allows you to fine-tune your plan using the most appropriate parameters.
- You can practice finding trade opportunities and recurring chart patterns while doing this test. This ability will be useful in your future research.
- You can tell whether a technique is worth implementing into real-time trading, saving you money and time.
- The study allows you to test your strategy under different market conditions. This way, you can tell whether the strategy is best suited for trending or consolidating markets.
As aforementioned, backtests can be performed either manually or using automated programs.
The backtest is done by manually perusing through the charts from some time in the past to the present day. While doing so, you record all the trades that are identified by your strategy and record their gain, whether positive or negative.
This process can be tedious and can lead you to errors, more so if you have hundreds of trades to analyze or even more. However, it gives you a hands-on feel of how productive the strategy is in ever-changing markets. Further, it helps point out any individual elements of your strategy that may need to be improved.
These are accomplished by using an automated application that allows you to enter the parameters of your trading strategy and then search for trade opportunities that meet those parameters. There are various such programs available, some of which are free and others that charge a price. The Strategy Tester on the Meta Trader platform is the most popular tool.
How to perform a manual backtest
To effectively perform this test, you will require a few weeks of past price movements for your chosen currency pair if you’re a short-term trader. If your strategy is meant for long-term trading, you will require to revert back a few years on price charts. From here, it is just a matter of following these simple steps:
- Define each individual element of your strategy.
- Choose a currency pair and timeframe to apply your strategy. Each choice will yield different outcomes, so you can vary these on each reiteration to find out which combination yields the best results.
- Look out for trades that satisfy your strategy’s parameters. On the currency pair chart you’ve chosen, you can scroll back a week, month, or even year and start looking for trades from this point till the present day.
- On each of the identified trades, highlight the entry and exit signals and record them. You should record all trades, regardless of whether they hit their take-profit or stop-loss levels.
- Compile all recorded trades to calculate the gross return. This should be a profit if your strategy has profit potential.
- Subtract any commissions and trading fees associated with the trades to obtain the net return.
- Divide the net return by your starting capital to obtain the percentage return over the entire period.
You can vary several parameters of your strategy and repeat this process until you get the best results. For example, you could try out your strategy in different trading sessions to determine if it’s best suited for the New York, European or Asian session. Chances are, each session will yield a different outcome.
Backtesting vs. forward testing
As previously stated, backtesting is paramount in establishing a trading strategy’s profit potential. However, it does not take into account fundamental indicators and other variables in real-time markets. Thus it cannot guarantee the strategy’s future performance. As a result, it would be wise to couple it with forward testing.
Forward testing entails the evaluation of a strategy in real-time market conditions, usually with the aid of a demo account. Traders will typically scour the market for entry and exit signs as they happen. As a result, forward tests typically take substantially longer than their reverse counterparts. A strategy can be used in real trading if it passes both the backward and forward tests.
Backtesting is a process whereby traders apply their strategy to past price charts in a bid to find out how successful their strategy is. It works on the assumption that a strategy that was profitable in the past is also going to be successful in the future. You can perform this process manually or utilize an automated program. For best results, this test should be used in conjunction with forward testing.