Reasons why backtesting will help you improve in forex trading

The foreign exchange market (Forex) is the largest market in the world in terms of trading volume where global transactions average trillions of dollars per day. When planning to venture into Forex trading, especially for the first time, one must realize that this huge and unique exchange market is affected by many factors, which make it so volatile, upon which currencies rise and drop.

Conditions in Forex trading can turn sharply virtually at any moment depending on:

  • Political and economic factors
  • Trader perceptions

For example, trading on a currency that has been doing relatively well could experience major downturns in unexpected times of political instability; political events that occur in a country that effectually cause economic losses.

Reported economic policies or changes to it, positive to investors or otherwise, can also sway Forex trade conditions. Needless to say, it is impertinent to be aware of practically everything that goes around that may be perceived to have an effect, directly or indirectly, on how a market eventually performs.

These trading signals serve as a basis for a trader to buy or sell a currency pair at a given period of time.

Therefore, while the lure to earn substantial amounts of money is strong in the foreign exchange market, this unpredictable characteristic serves as a cold warning that you could lose so much as well.

Importance of trading strategies and the need for backtesting

Think of the aforementioned factors as hurdles towards achieving your goals, and it becomes absolutely necessary to set up trading strategies, likened to a game plan, on how to approach the Forex market challenges.

You need to come up with a sound trading technique first before attempting to make your first currency trade. If you plan on making random decisions on the go, you can’t be expected to go that far, even if you initially turn out lucky.

Long-term goals need to be supported by rational strategies, calculated risks, and sound decisions, which all come from extensively studying your trade.

With rational strategies and calculated risks, achieve long-term goals through backtesting. Click To Tweet

When drafting your trading strategies it is vital to outline what your expectations are. How much do you expect to earn? How much are you willing to lose before calling it off?

When venturing into forex exchange trading you must decide on which currency pair to go for. Learn everything there is to learn about the factors that govern it, bank on its inherent advantages over other currencies, and know when the time is right to buy or sell. Openings can be very brief, so timing is everything.

No matter what decisions you arrive at in the process, it is important to always document your trades. Why?

This will lead us to the focal point of this article: Backtesting.

Backtesting is important to test if your trading systems are effective and profitable

Backtesting allows you to test your trading strategy before going for a live trade. This means that you can have the luxury of seeing how it performs without losing actual money in the process.

It is a modeling technique that uses historical data, and with all the knowledge derived from it, come up with a pattern on how to predict the foreign exchange market. The idea is that if a strategy worked well in the past, it is supposed to work well in the future, and vice-versa.

With all the external and internal factors at play in Forex, backtesting is an attempt to make sense of all the complexities, in a way. It’s like taking a step back and taking a bird’s eye view of the system as a whole for a better understanding.

This means courageously taking into account all that works in your methods and what doesn’t. Having an objective study of the whole system to test its limitations because no trading strategy is perfect.

This technique gives you a better view of how things build up, how to detect trends and take advantage of it, how a current model would have worked in the past. If it does well in backtesting, then the trade rules should be ready for forward testing as well.

How long should a trader backtest to achieve predictable value? Take in as much pertinent data as possible from various situations. Chances are, most major changes in currencies and prices take place when major activities occur in the news. Take note of these things, of times when things went well or roughly.

Take in diverse, yet relevant information across different times and scenarios. The more relevant data you can gather for backtesting your model, the more stable a long-term strategy may be derived out of historical data. Key-in ratios, prices, timeframes; all information needed to prepare your trading strategies against all possible types of future trade conditions.

For positive backtesting results, simulate tests seriously and never take the process for granted. Click To Tweet

Benefits of backtesting

Instead of directly undergoing forward testing or live trading, backtesting actually saves you a lot of money by lessening the risks involved. The more prepared you are through studies, observations on historical data, the better. It saves a trader not just money, but valuable time in analyzing if a particular strategy or set of rules will work or not through preliminary simulation.

Through studying historical data, not only will a trader feel more in control and gain some degree of expectancy by understanding if a trade system is profitable or not, but more importantly, one gains confidence in how a trade strategy really works.

You can test a method as many times as you believe is necessary, and make the necessary changes if you have to.

There won’t be a need to panic if it goes through an expected low period, for testing timeframes are taken into account along with other trade indicators.

Backtesting helps a trader follow specific rules that are necessary in Forex trading. Therefore, the way you operate is more disciplined, especially in a chaotic, high-strung trade market scenario with so much money involved.

Conclusion

Always take note of volatility and how it affects the market. You can take into account years of historical data and still fail to predict how currencies, governments, and markets may behave moving forward. Backtesting does not guarantee success, but by being prepared it lessens the financial risks by taking steps to attain consistency in patterns, and deeper trade understanding.

Therefore, while backtesting, it is vital to be as patient as you can. Take note of relevant details, what goes around between trade partners, how interest rates rise and fall, or how economic decisions are being made. Backtesting may be more effective when all relevant scenarios in the financial milieu are taken into consideration.



Joevren Curmi

Joevren is a content manager at Keen LTD. He is passionate about investing and spends most of his money from his investments on travel. In addition to being a content manager, he also works as an internet marketer for his own business. He believes that the internet as well as trading are the best tools of today’s time to speed up one’s progress towards financial freedom.

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