Forex back testing is used to seek validation of how a strategy is likely to perform when used in a live market environment. Essentially it provides a yardstick of performance. The theory is that if a strategy has performed well in past markets then it will continue to do so in future markets, because repeating price patterns in the market form the basic principles of technical analysis on which so many trading strategies are based.
The back testing of system strategies proves popular with traders for two main reasons
Firstly the available data needed to carry out the testing is easy to acquire with the testing process itself being relatively easy to perform. Many of the leading charting packages such as FXCM facilitate strategy testing in just a few clicks. The output provides a comprehensive statement of the historic performance of the strategy. This will be inclusive of, a breakdown on the profit / loss ratio of the trades taken, the number of winning / losing trades by direction (long and short) and the all-important draw down levels on the account.
Secondly, it provides a foundation with which traders can quickly make a judgment call on the success or failure of a strategy with a specific currency pair. Often the strategy is repeatedly run through the testing process in order to find the highest level of performance. Tweaks made to the strategy may include adding or removing technical validations or simply moving profit targets or stop loss levels. The ultimate aim here of course is to increase the profitability of the strategy.
However it is important to remember that back testing can only ever validate how a strategy performed against historical market prices. It can make no prediction of whether the strategy will work either in current or future markets. The central flaw of this method is that it assumes that markets will always behave in a similar manner. However the dynamics of the markets are constantly changing so we have to learn to adapt with them.
An area that is generally never factored into back tested results is the trader himself. This is because back testing assumes that the trader will always act upon the strategy in a uniform way. Even in the case of automated systems, there is no guarantee that the trader will not change parameters or interfere with running positions. The trader himself is one of the biggest variables to the success or failure of a strategy and the fundamental element that back testing cannot account for.
The only assured way to evaluate a strategy is by measuring actual strategy performance. And by this we mean in a live environment. While this may undermine the confidence of fledglings to the industry, it does not have to be a costly mistake. Trading with small lots and sensible leverage means that a strategy can be evaluated with a minimal account size. Only once you are confident should you increase your stakes.
By approaching strategy testing in this way, not only will you reach a much more credible evaluation of the strategy, you will learn a lot more about real trading as well. Back testing of recent history shows us a clear indication of recent market sentiment and behaviour. The repetition of price action movement is often seen in a cyclical form, when repeated on the same day of the week and the same day / date of the month. It is also possible to deduce the size of potential profits, by measuring recent moves, often conducted between S & R, and in conjunction with pivot points and EMA’s. Having a basic understanding of the recent history of a particular currency pair is paramount to success.