Just as all new technological and other products go through rigorous testing before launching, so do trading strategies in forex. No one should underestimate the importance of thorough testing.
Many struggling traders have not tested their strategies to discern their profitability in the long run. This lack of trial and error leaves one frustrated and insecure without direction as to what they could fix to maintain a consistent path.
It becomes challenging to quantify one’s performance without testing reference points. Ultimately, speculating in the markets is using past theories to make analytical judgments about the future. In forex, we have two main types of testing, backtesting, and forward testing.
This article will cover the differences between the two and how traders should use both in conjunction before trading forex.
What are back-testing and forward testing in forex?
Backtesting is an approach to assess how a particular system or strategy will perform using past price information. This type of testing is performed manually or using special software and applies to discretionary and automated trading methods.
Whether consciously or not, any new trader on a demo account already performs backtesting by sifting through weeks, months, or years of price data on charts. The investor may have likely picked up a strategy from a mentor or online and looks to see whether it can be profitable in a live situation.
With one ironic exception, back-testing does indeed form part of the puzzle for building and solidifying a profitable strategy. As the old axiom states, past results are no surety of future performance; back-testing is technically only an assumption that what worked historically will function the same henceforward.
This is where forward testing attempts to fill in the blanks. Forward testing takes those findings from back-testing and trades them in real-time on a demo or real account.
The trader can then validate precisely how effective and profitable a particular trading strategy is with little partiality and room for error.
The importance of testing in general
Testing boils down to vast data accumulation and statistics. Traders worldwide all perform at different levels. Someone who has little idea of how effective their trading system is will likely doubt themselves and probably look for a new system.
A seemingly infinite number of strategies exist in the realm of forex. The question then comes to how profitable these are and under which exact conditions. At a bare minimum, the point of having a strategy in the first place is defining precise entry and exit points.
The hardest part is outlining the conditions of precisely what parameters should be in place before considering entering a position. Any slight alteration in such guidelines can dramatically change the results and performance.
These are all the factors a successful trader will know well in advance, attesting to the significance of testing in general.
Placing more significance on forward-testing than back-testing
It’s easy to determine why forward-testing is far more paramount than its counterpart. Back-testing is simpler to assess but falls victim to favoritism and lacks the ever-present psychological aspect when trading real money.
Unfortunately, many traders don’t spend sufficient time forward-testing because of its vast time consumption. However, shying away from this element is one of the several reasons traders lose money in the long run.
Everything starts from back-testing. The typical journey involves picking an existing strategy or creating one from scratch. The trader will define a set of criteria, noting them down and tallying up the results of numerous outcomes based on those parameters.
Even if the outcomes are positive, it doesn’t necessarily mean they will remain as such when traded live. Back-testing has its limits here because a trader might execute slightly differently from what they did using past data.
So, before going live, one would need to trade the strategy on a demo account preferably and maintain flawless execution based on the rules set in the back-testing phase.
Overall, both methods function in sync, with one leading onto the other.
Combining both back-testing and forward testing in forex
Below are the logical steps any serious trader will follow from back-testing and forward-testing.
- It starts with finding a strategy and its defined entry and exit points. For example, let’s use a simple 20 and 10-day Moving Average crossover. We presume a buy signal when the 20-day MA crosses the 10, while a sell signal occurs when the 10-day MA crosses the 20. Lastly, let’s also assume the stop loss will always be 25 pips and the profit target is 50.
- A trader would then decide how many markets to trade with this crossover system and on which time frames.
- At this point, depending on someone’s inherent trading style, the analyst will use the selected charts and go as far back as possible on their chosen time-frames. The point of going back in time is observing how the previous entry and exit signals played out in the past.
- Perhaps the most important part of the entire back-testing is tallying up the winning and losing trades. Overall, the trader needs to assess how happy they are with the net return of all positions taken.
- After gathering all the results, the trader would open a demo account. Some recommend a nano live account allowing the trading of nano lots, meaning traders can put down little real money.
The latter may be a better option as traders will learn how to deal with the emotional side of trading that is harder to mimic in a simulated environment.
- One overlooked element to testing is time. Traders must give themselves at least a year in the forward testing phase.
An effective trading strategy has been tested through a plethora of different market conditions, which are hard to witness in their entirety within a short period.
- Lastly, another critical step is journaling all outcomes after forward-testing by seeking vital data such as average risk-to-reward, expectancy, win percentage, maximum drawdown, return, and profit factor.
Traders often fall victim to hindsight bias as it’s much simpler to conclude profitable outcomes by peeking at the left side of a chart in back-testing. But what about the right side? This is where forward-testing comes into play. Using both testing approaches allows one to know what to optimize and tweak for maximum efficiency.
Ultimately, all profitable traders have gone through lengthy, rigorous, and iterative trial and error processes before finding out what works best for their time availability, skill, preferences, and experience.