In order to become a successful forex trader there are some steps you need to follow. One step is selecting a suitable trading system which fits your risk profile, view of the market and trading patterns, but after the next step is to backtest your trading system.

Backtesting is the process of testing your trading system against past period market data and finding what trades your system makes and how profitable it is in different trading conditions. Read on to find out more about backtesting your trading system.

Purpose of backtesting

Forex trading is fast paced. You might be able to conduct some short term trades and make a small profit but you won’t be able to go too far trading by the seat of your pants. To succeed, you need to have a proven trading system which will analyze the market data and will provide signals on when to enter and leave each trade.

Backtesting of your system before entering the real market is vital. Through the process of backtesting you can understand how effectively your system would perform in the market. It will also give you the opportunity to make necessary modifications to your system to improve its performance.

The backtesting process doesn’t only help you to understand the efficiency of your system but also gives you the confidence that you can rely on it when you will face the forex market. If you are not quite sure about the effectiveness of your trading system then you probably won’t be able to trust its trading signals. This takes you back to square one, making trading an emotional matter with confusion, hesitation and other psychological factors which a good system should eliminate from your trading.

So the basic purpose of backtesting is to improve the capability of your trading system to give you the right trading signals and gain confidence in your system’s trading signals so that you won’t second guess your system.

Backtesting process

Many trading packages make it easy to backtest your system. You simply need to select the data to ensure that your system is not over optimized. This means that it will perform well in only one market situation, but will not be profitable in real life.

Use the following rules to select your data and ensure that your system will stand up in real life trading:

• Perform the backtesting with a huge amount of data (at least 1000 data periods) to make sure that your system is analyzing enough data under different market conditions. It will help you to understand its performance in various types of market movements.
• In order to get a realistic result make sure that the data you are choosing to test against is comparable to the real market scenario.
• To have flexibility in your currency trading, include wide range of data that will cover a large number of currency pairs other than the major ones. You can concentrate on trading particular pairs but bringing in more data will help you to understand the accuracy of your system against other currencies so that if you ever want to trade other pairs, you will have full confidence over your system.
• Include a realistic amount of slippage since in a volatile market this is something your system will have to deal with.
• Using the sample data for backtesting is not going to let you get the real picture. These sample data are the ones on the basis of which your system was developed. So you need to include data out of the sample to understand how your system will act in more realistic situations.
• Include data of different time periods where the market experienced changes due to different political, economical or other reasons. It will help you understand how your system will execute the calculations in those kinds of situations as they can happen in any time in the forex market.

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Tags: backtesting, forex trading, trading system

This entry was posted on Sunday, December 28th, 2008 at 9:41 am and is filed under Trading Systems. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.