A forex trading strategy, at the very least, should be capable of pointing out trade entry and exit signals. Once you have such a strategy, you can pass it through a number of tests to determine its feasibility. You can opt to use your strategy on past data and compare its instances of successful trades against failures. This is known as backtesting. Similarly, you can use your strategy on live charts to find out its chances of success in real-time trading. This is known as forward testing.
Backtesting, as previously stated, is the practice of evaluating the performance of a trading strategy using historical data. This is an important part of developing a viable trading strategy. Every trading method involves a variety of variables, and changing just one of them might make or break your trading approach. This testing allows us to see which settings are more effective than others.
It goes without saying that before you can backtest, you’ll need a trading strategy. This trading strategy should be able to highlight entry and exit points for suitable trades and the ideal position size. Further, it should provide a context of the trades, like under what conditions a trade should be entered. This could be anything from when RSI shows oversold conditions to when a Moving Average crossover happens, or it could even specify certain times of the day.
Backtesting can be done manually or with the help of computer software. The latter is simpler because it just necessitates the use of testing tools. This software looks for trades that meet the strategy’s requirements, then totals all winning and losing trades over a specified time period. By comparing these, it is possible to determine whether the plan is lucrative and, if so, how likely it is to succeed. Traders evaluate historical charts using their approach and tally the outcomes manually in manual backtests.
How to perform a manual backtest
First and foremost, you’ll need several weeks of historical data if your strategy is designed for scalping and day-trading. If your strategy is designed for long-term trading, you may need several years of historical data. Once you have this data, these are the steps to follow:
- Set the parameters of your strategy.
- Identify the currency pair and the chart timeframe you intend for your strategy to be used. In this step, you should also specify how far back you need to run your backtest. This could be a week, several weeks, a year, a decade, etc.
- Identify trades picked out by your strategy criteria.
- Analyze the charts to find out all entry and exit signals.
- Tally the results of both successful and unsuccessful trades—the difference between these yields the gross return, which could be a profit or a loss.
- To obtain the net return, deduct any commissions and other trading fees related to the identified trades.
- To obtain the return in percentage, divide the net return by the initial capital required to make the trades and multiply the result by 100.
The percentage return gives a measure of the success of your trading strategy. If the results are subpar, you can always adjust your parameters and repeat the above steps.
We’ve demonstrated that backtests are critical for establishing a trading strategy’s historical performance. However, because economic developments and other market variables are not taken into account, these results do not necessarily translate to live trading. As a result, you should not rely completely on this testing. It’s also a good idea to run a forward test to see how profitable your approach is under real-world market conditions.
Essentially, forward testing is simulated trading. In this process, traders paper-trade their strategy in the live market. Consequently, it is a slow process because trades are entered and tested in real-time, as opposed to backtesting, where you can cram years of trades in one day.
When backtesting a strategy, it’s possible to use overly exact parameters that provide perfect entry and exit signals but don’t predict future price movements. Forward testing is used to solve this problem. Because forward testing uses live data to determine the true value of a strategy, any overfitting of parameters can be discovered.
Backtesting can be narrowed down to determining whether a suggested technique has profit potential. Forward testing can either validate or disprove the strategy’s profitability in this scenario.
How to forward test
You can choose to forward-test automatically using a Meta Trader tool known as a strategy tester or perform it manually using a demo account. If you choose the strategy tester way:
- Choose the historical interval you want to backtest your strategy on.
- Split it four ways, and set it such that a quarter of this interval is forward of the testing period.
In general, the more data you use in your backtest and the longer the period you employ in your forward testing, the more accurate the findings are. Furthermore, manual forward testing with a demo account, however time-consuming, tends to produce better outcomes because it entails testing your technique in situations similar to real trading.
In a nutshell
Backtesting is the method of verifying the viability of a trading strategy by calculating its percentage gain using past data. You can evaluate if your approach has the ability to produce profitable trades based on these findings. Backtesting, if done solely, is insufficient. After passing this test, you should put your method through real-time trading to see if it is lucrative in genuine market conditions. Forward testing is the term for this. These tests can be performed manually or automatically using testing tools.