Backtest Your Forex Trading System!

What if you knew that there is one habit that you can adopt as a trader that will nearly guarantee trading success? What if you knew that all professional traders share one habit in common? Furthermore, what if you knew that this simple habit allows these traders to trade relaxed, that this habit allows these traders to anticipate the future because through this habit these traders have learned what to expect, and by adopting this habit professional traders have incredible confidence in their abilities to extract profits from the markets?

Wouldn’t you like to know what this habit is?

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This habit is the one thing that all successful traders have in common. It may come as a surprise, but even though this secret habit is by far the single best predictor of trading success, many traders choose not to adopt this habit. Few traders choose to consistently adopt this habit, and we know that few traders consistently make money trading forex. Is this a coincidence? Probably not. This one habit is the single most important thing to a trading success…and many successful traders will emphasize this point. And yet, many unsuccessful traders refuse to adopt this habit.

This one habit that successful traders share is this: successful traders backtest their trading systems. They take the time to pour over data, using one of three backtesting methods. By backtesting their trading strategies they become more relaxed in their trading, and this is because they have seen their trading system perform over years in thousands of situations. These traders have learned to anticipate the future because they are intimately aware of the characteristics of their trading systems and will often develop a ‘sixth sense’ about the markets simply from viewing the markets through the filter of their trading systems for so long. This sort of experience can only come when a trader sees a trading strategy perform over years and in a variety of market conditions. And finally, these successful traders have confidence that their trading strategies will prevail in the markets because they have seen their trading system work in the past, and they know that it will work in the future.

Perhaps it is intriguing that most traders refuse to adopt this simple habit, or ‘don’t have time’ to backtest trading strategies. For many traders it may be like that foreign language, or that cooking class or perhaps that classic novel that was on the ‘to do’ list. Maybe it is not too surprising that many more traders lose money trading – only the profitable traders get around to backtesting their trading methods.

Methods Of Backtesting

If you have decided that you would like to become a profitable trader, and you want to make backtesting your habit, you have a choice as to how you might make backtesting your habit.

1. Manually Backtest

Only one kind of system testing makes sense. It is slow, it is time-consuming, and it does not lend itself to testing a hundred markets at once, but it’s the only method that prepares you for trading. It consists of going through historical data one day at a time, scrupulously writing down your trading signals for the day ahead, then clicking your chart forward and recording the trades and signals for the next day.

Alexander Elder, Come Into My Trading Room – As Dr. Elder explains, manual backtesting is very slow, and can be boring. But the experience you gain from it is well worth the time spent. You not only learn what it is like to experience the ups and downs of your trading system, but you also can learn the importance of keeping good records, which helps the budding trader in his quest to treat trading as a business.

This type of backtesting is limited only by the amount of data that the charting software can hold in the chart. Tradestation, Intellicharts and Metatrader both can hold enough data to make manual backtesting possible.

2. Backtesting Software

This is my favourite way to backtest systems. It is easier than manual backtesting, because the software records the data for the trades (thus it is usually faster than manual backtesting), and the backtesting experience is similar to trading a Metatrader account. The best backtesting software available is forextester. This software makes it easy for you to “trade” the past. You can literally “trade” your trading system for years and learn what the system does well, what it doesn’t do well and what you can expect if you are to trade the system in real time.

I don’t make any money if you buy forextester, but I strongly believe that most traders would make more money trading if they used this software to test trading systems

3. Program Your Trading System

If you are a computer programmer, then this sort of backtesting will appeal to you. Basically you are going to ask the computer, through some software interface, to go back in time and take the trades according to your trading system rules. This is automated backtesting. While it may seem to be the easiest and best method to efficiently conduct backtesting, it is not without limitations.

There are several reasons why for most traders, it probably is not the best choice. First, this sort of backtesting makes sense if you are going to let a computer take your trades for you, but unless you are comfortable leaving a trading robot to do your trading, then this type of backtesting is probably not going to replicate what you are going to do in real life, with real money. This is because once you start trading you are going to watch the chart unfold, and you may make your decisions based on what is happening in the market. With automated backtesting you do not see the trades unfold, you only see the end result of the trades.

Second, it is often tricky to program the precise trading system that you would like to test. For example, if your system is designed to take trades during the European trading session, then you would certainly want to make sure that the program excludes trades triggered during the Asian session. This type of programming can be involved and difficult.

Third, you will still need to manually check at least some of the trades to verify that the program tested your trading system rules precisely as you expected. Fourth and finally, when using software to program your backtesting, you need to be very careful to avoid biases in backtesting. These biases can come up in any method of backtesting, but are particularly easy to incorporate into automated backtesting.

Walter Peters, PhD is a professional forex trader and money manager for a private forex fund. In addition, Walter is the co-founder of Fxjake.com, a resource for forex traders. Walter loves to hear from other traders, he can be reached by email at walter@fxjake.com.

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