What Does it Mean Backtesting Forex Trading Strategies?

Forex trading can be a challenging and unpredictable landscape, requiring traders to develop and refine effective strategies, applying in-depth market research and well-thought-out tactics to navigate the market successfully. One critical method traders employ to test their methods before putting them into action is backtesting. Traders can practice their trading strategies in a simulated environment before using them in the real market. 

In this article, we will examine the concept of backtesting, its role in Forex trading, how it can enhance trading performance, and what kinds of simulation techniques and resources are available to traders in their pursuit of success.

What Are the Odds of Finding a Profitable Forex Strategy on the Internet?

The practice shows that the answer might be disappointing. 

What makes the difference between a lucky guess and profound trading? Are you sure your trading style is more than just flipping a coin and expecting a positive outcome?

Or you are probably overwhelmed by the number of online trading strategies promising to bring a fortune. Want to know how to avoid desperate confusion when the "simple" systems only drain your live trading account?

Find the reasons why backtesting became the only reasonable way to trade smart. Please keep reading to learn how it is easy to confirm or disprove any trading theory with the power of backtesting and elementary school math.

We'll focus on a series of backtesting experiments with one aim – to show traders (both beginners and professionals) that you shouldn't take anything on trust, especially if you risk real money, and you should double-check ANY information found on the Internet related to trading.

We will not teach you the importance of technical analysis, but the math calculations speak for themselves.

What is Backtesting a Forex Trading Strategy?

Foreseeing how a trading method would have fared in actual market circumstances, backtesting allows traders to examine that method's potential results. Backtesting software allows traders to explore their practices and improve based on historical data. A trading simulation aims to find flaws in a strategy and improve it to generate a higher return on investment.

Simulating market conditions can backtest a trading strategy in the past. The goal is to evaluate the strategy's efficacy on the premise that a strategy's track record indicates its future success. To do so, traders run hypothetical trades using past price data and examine the outcomes to ascertain the strategy's win rate, profit potential, and level of risk.

Why is Backtesting Important?

There are several reasons why backtesting trading strategies is so essential. The first thing it does is support traders in finding any weak points in their methods. Traders can assess a system's viability in various scenarios by testing it against historical data. To fix any flaws in their trading system, traders can now easily see them.

Second, the simulation process might increase traders' confidence in their strategy. Traders forecast a system's future performance by simulating it using previous data. This helps traders feel secure enough in their approach to use it in real-world Forex market.

Last but not least, backtesting aids traders in gauging the success of their trading strategies. Traders can learn whether a system is profitable by testing it on existing data and then fine-tuning it based on the results.

When and How Should You Backtest a Trading Strategy?

There are specific measures that traders must take while backtesting trading strategies. One of the first things they must do is determine the parameters of their trading system. The parameters include the entry and exit points and the stop-loss and take-profit levels.

The next step for traders is to compile data on the chosen currency pair's past performance. The open, high, low, and close prices for each day under consideration should all be included.

After accumulating this information, traders enter the rules of a trading strategy into strategy tester and see how well it performs under simulated market conditions. The system rules and past data will be used to model the outcomes of trading positions.

After the simulation phase, traders assess their strategy's efficacy. The only essential parameters that must be analyzed are the win rate, profit factor, and maximum drawdown. Traders then optimize their systems using the data gleaned from the simulation app.

Backtesting Steps

Investors take a few standard procedures to backtest a trading strategy. They start by picking a horizon for the simulation and a set of the Forex market indicators to examine. Such information includes pricing records, fundamental events, and similar records. The next step is for the trader to enter their trading strategy into a backtesting software tool, which uses the method and historical data to generate simulated trades. Forex Tester is one of the best trading simulation software products available in the industry nowadays. The app is user-friendly and has dozens of useful functions with different approaches in the trading simulation.

5-Steps Plan to Score the Best Results While Backtesting Strategies

You will totally agree that:

It would be easy to perform a simple backtest as depicted above. Nevertheless, to get deeper into the topic, we included some math to make the experiment results more illustrative.

No boring math, don't be afraid.

What is the reason behind such a complex approach?

The following calculations help to save your precious time and effort and bring up the entire backtesting process to a new, more precise level.

How can the trading strategy work under the pressure of the various market conditions? We solve this issue quickly with the idea of the Training Set and Forward Testing.

We performed several experiments to increase efficiency within the historical data's short period and compared the results.

The entire process will take 5 STEPS:

1. We defined periods of the market when it was mainly Bullish, Bearish, and Flat. As for the Bull market, we take the period from 14/02/2011 to 25/04/2011. The Bear market refers to 18/08/2014-19/01/2015. The Flat market continued from 15/08/2016 until 03/10/2016.

2. We test the chosen strategy within the conditions of the Bull market and enter 50 trades – this is how we form the Training Set; next, we perform the same backtesting for the Bear and Flat markets within the range of the dates above (again 50 trades at each);

3. To perform Forward Testing, we define more periods of the same three markets: 

• Bull market – 09/06/2010-01/11/2010

• Bear – 01/09/2011-16/07/2012

• Flat – 04/05/2015-12/10/2015

4. Then we enter the 20 trades at each of the markets, creating the Forward Testing set this way.

5. The last but most crucial step – with a sense of accomplishment we compare the results and make conclusions.

Disclaimer: it is impossible to test all the variations of the strategies, theories, and trading ideas – there are tons of them. If you have not found the method you are currently interested in among the ones we have backtested, feel free to backtest trading strategies it yourself and share your opinion.

Moreover, we cannot guarantee the ideal performance of the Forex trading strategy during the live trading, even if it turns out to be profitable during the backtesting.

The backtesting gives you statistically proven confidence in your trading decisions to some extent. However, we sincerely believe that without it, trading becomes a synonym for gambling or a lucky shot in the dark.

Please remember that you use the backtested Forex strategy on a live trading account at your own risk.

Analyze the Results

Traders may evaluate the backtesting outcomes and make any improvements to their trading strategy. The entry and exit positions, stop-loss levels, currency pair, and other Forex trading strategy elements may need to be modified. To improve their decisions in real financial markets, traders may learn how their methods fared under varying market situations by first testing them on historical data.

How to Adjust Settings and Compare Results

You might be wondering:

If the backtesting experiment shows pessimistic results, should it be the reason to discard the trading strategy and search for the new one?

We pick the trading strategies with commonly used indicators, default settings, and suitable timeframes for experimental backtesting. However, as a trader, you understand that various settings, indicators, timeframes, and currency pairs give you endless opportunities to perform experiments.

What can be a matter of the additional change and backtesting within the strategies?

• Stop Loss and Take Profit –you can try to change them accordingly, increase or decrease, they can have equal meaning, or the riskiest ones can try to backtest a trading strategy without Stop Loss and Take Profit and close trades manually based on the signals from the indicators (however, we strongly do not recommend you are doing this);

• We use the default setting of indicators. However, you can backtest the custom settings – you never know what can work the best for a given currency pair;

• Timeframe and the currency pair: some traiding approaches might work better on specified conditions;

• The entry points of the trade;

Very important: we set the spread meaning to 1 point during the backtesting sessions. Please check yours because the spread matters – the larger it is, the larger the profits you should have to cover the difference. Besides, trading conditions might vary from one broker to another, so Forex traders should match them within the strategy tester to get real trading costs.

The only reasonable way to learn the odds of earning money using ANY trading plan – is to put it to the test.

How to Read the Results?

What is the way to compare the results of the Training Set and the Forward Testing?

The main idea is that performing successfully during the 50 trades of the Bull market period, for example, a trading strategy usually will show mostly identical results during the Forward Testing.

As for calculations, we receive the Training Set results by dividing the profitable trades by the whole number of trades. The same way we get the results for the Forward Testing automatically. In contrast to paper trading, the simulation with the Forex Tester software provides instant results for in-depth analysis.

The numbers we receive should match more or less for satisfying results. Besides, we will check the periods in the strategy tester – any professional trader wants to recoup his investments within a shorter period.

Why is Backtesting Crucial in Forex Trading?

There are several reasons why backtesting is very important when trading Forex:

• Backtesting is a valuable tool for validating trading techniques before they are used in real life. As a result, traders may assess the strategy's viability and profitability before committing to it.

• Risk Management: Forex traders may evaluate the potential loss associated with a specific system by looking at its past results.

• Trading simulation helps traders optimize their methods by revealing weak spots in their entry and exit locations, risk-reward ratios, and chart timeframes, among other areas. It would take much more time to backtest a trading strategy with paper trading on a demo account.

• Trading with confidence comes from knowing that your method has been thoroughly tested and has performed successfully under various market situations.

Types of Backtesting Methods

Three basic approaches exist for simulating historical market conditions while developing Forex trading strategies.

Manual backtesting

Manual backtesting requires the trader to manually examine price charts from the past and apply their trading method to those circumstances. While it is time-consuming and prone to human error, this approach may provide traders with valuable insight into the performance of their strategy and the market.

Trading simulation

The performance of a strategy may be evaluated by simulating real-world market situations in the past. Traders may determine the strengths and weaknesses of their approach by replicating historical market conditions. In contrast to a traditional demo account with forward testing in real-time market conditions, this method allows traders to hone their Forex strategies and gain essential insights before risking real money in the live market, thereby improving their decision-making processes, increasing their chances of success, and saving them time.

Algorithmic backtesting

Backtesting a trading strategy automatically using dedicated software is known as algorithmic backtesting. The program allows traders to enter their strategy settings, generating hypothetical transactions based on past market activity. Although automated backtesting improves upon manual simulation in speed and accuracy, it may only consider real-world aspects that affect a strategy's success and may need some familiarity with programming languages.

Tips for Effective Backtesting

Traders who want reliable backtesting results should stick to a few tried and true guidelines. Traders should first take advantage of reliable historical price data. This information must be complete and correct, including OHLC prices and tick data.

In addition, traders should only employ trustworthy backtesting software. The strategy tester should model transactions according to the system's trading rules and past data.

Traders should only optimize their strategy based on simulation results. An over-optimized system may need to be simplified and easier to understand. Traders should implement a technique that has a slight learning curve compared to paper trading or a demo account, and produces consistent results.

Try it Yourself with Forex Tester

Setting up a testing environment in Forex Tester is the first step to backtest Forex trading strategies. To do this, we must first import historical data for the selected currency pairings and periods, taking care to import only complete and accurate records. Traders may simulate their trading situations by importing relevant data and setting settings such as starting account balance, leverage, and other conditions. With the backtesting software's intuitive interface, traders can easily adjust these parameters to simulate market conditions that are as realistic as possible before placing actual trades.

After setting up the Forex Tester software, traders may try their preferred trading method before committing to real money. This process includes using the required technical indicators, establishing entry and exit rules, and determining risk management parameters like stop-loss and take-profit levels. As the software allows for creating custom indicators and a wide variety of pre-made ones, traders have a great deal of leeway in using Forex Tester for the trading strategy backtesting. Moreover, the program allows users to choose their preferred approach, whether manual backtesting or automated backtesting.

When traders set up their trading strategy, they may begin simulating it in Forex Tester. Traders may keep tabs on their transactions and examine their results in real time with the help of the software's powerful visualization capabilities. Users may also alter the simulation speed to experiment with different tactics or examine individual market occurrences in more depth, both of which are available in Forex Tester. After finishing the simulation, traders may fine-tune their trading methods for better profitability and decreased risk by reviewing comprehensive performance data and reports.

Final Word

A successful trading strategy can only be created by first being backtested. Any trading approach must first be tested using historical data to reveal flaws. Trading systems may be tested against historical data to assist traders in assessing their success. High-quality historical data, reliable backtesting tools, and avoiding over-optimization are all essential for successful simulations. Following these guidelines can create a successful forex trading strategy and confidently enter the financial markets.

Backtesting is an effective method for investors to evaluate and improve their trading plans. Traders may enhance their results by identifying their weak spots and fixing them using historical data analysis and trade simulations based on their approach. The results of a backtest cannot be extrapolated to the future, but the knowledge and information gained may help guide trading choices in the real market.

Backtesting your strategies is the ultimate secret weapon in the thrilling world of forex trading. It's the difference between shooting in the dark and hitting the bullseye. And with Forex Tester by your side, you have the power to unlock this incredible advantage. So, why wait? Take control of your trading destiny and embark on a journey of success. Don't let opportunities slip through your fingers.

Invest in Forex Tester today and join the ranks of savvy traders who understand the importance of backtesting. Experience the thrill of making informed decisions, the joy of minimizing risk, and the satisfaction of watching your profits soar. Take the plunge and seize this opportunity to become a master of forex trading. Your future self will thank you. Buy Forex Tester now and unleash the power of backtesting like never before!