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What is backtesting and is it required to become a professional forex trader?

Updated: Jan 11

I’m a big believer in backtesting a forex strategy. Why? Because why would a strategy start working all of a sudden if it hasn’t worked in the past? The past is not something to fully rely on, but it’s something that can be very useful in determining if your trading approach works, or at least, has worked in the past. Therefore, backtesting is useful. But, how to backtest forex? How to manually backtest a strategy and what to consider when doing so? In this article, you will find the answers.

What is backtesting?

Backtesting is the act of looking at past price data and testing your trading strategy over this data in order to figure out if it has worked in the past. The point of backtesting a forex strategy is to figure out if a trading strategy has worked in the past and how well it has worked. The point is also to figure out when the strategy works and when it doesn’t work. By keeping detailed statistics during backtesting, you can figure out a potential winrate, average R & expectancy, which are important statistics for profitable trading.

Is backtesting useful?

Yes, backtesting is extremely useful. Backtesting in forex allows you to see if your strategy has worked in the past. Most people learn a trading strategy and they expect it to work from day one. This will never happen. You need to test everything. Has it worked before? In which market conditions has the strategy worked? What to consider when trading the strategy? How big are the drawdowns? Backtesting gives you information about all these things, which can serve as guidelines for trading a strategy live.

Another benefit of backtesting is that it builds massive confidence. If you know your strategy has worked for the past 10 years, it gives you a lot of confidence to keep trading the strategy even after a losing streak. And, that’s exactly what most traders struggle with. Backtesting can fix this issue. Backtesting in forex can make you a consistently profitable forex trader.

How to backtest a forex strategy

Alright, so you now know what backtesting is and why it’s crucial to become a profitable forex trader. What’s next? Taking action of course. If you know me, then you know I’m a big believer in taking action.

So, how to backtest a forex strategy?

It’s done by following the following steps:

  • Creating rules around your trading concepts

  • Creating a clear trading plan

  • Creating an excel sheet

  • Determining the best backtesting method

  • Consistently testing your strategy

  • Tweaking & improving

As you can see, a lot goes into backtesting. Most people never backtest and when they do, they do it wrong which causes the data to be unreliable. After reading this article, you won’t make these mistakes.

You want your live trading results to be the same as your backtested results. For my own trading, that has always been the case and that’s because I backtested the right way.

Creating rules around your trading concepts.

Each trading strategy consists of concepts. Concepts can be:

  • Breakouts

  • Reversals

  • Supply & demand

  • MA crossovers

Whatever you use, it’s fine. The point is, you want to fully understand the concepts you use. You want to know when they work, how they work and when they don’t work. Then, you want to make sure they fit with you. The next step? Building rules.

Without rules, you have nothing to measure.

Without rules, there is no structure.

If you trade breakouts, how do you define a breakout? Is it a breakout of a daily high, or is it a breakout of a 3-touch hourly level? Or, is it a break above an indicator? Be very clear about how you define a breakout. Be very clear about where your target is going to be and where your stoploss is going to be.

The less clear you are, the harder it is to backtest and to trade the strategy in real time.

Creating a clear trading plan

The next thing you have to do is to create a clear plan. In this plan you write down your entry, exit and management rules. You write these down in if-then statements. If price makes a daily close above yesterday’s high, then I enter a long at the close with a stop below the low and a target at 2R. This is an example of how clear you want to be.

Creating an excel sheet

The point of backtesting is to gather data about a strategy and to see how it has performed. So, track data. I manually backtest

During your backtesting you want to keep things simple. So, just risk 1% a trade during the backtest. The aim is to test a basic setup with basic rules. Then later on you can always improve. But, start simple.

Determining the best backtesting method

Depending on what type of strategy you want to test, you determine how you are going to backtest it. This is quite simple:

Is your strategy 100% mechanical and programmable?

If yes, then you can just go back over the chart, without needing a replay program.

If the answer is no, then you have to put in a simulator that allows you to replay market price action without you seeing the future.

This is crucial. If you pick the wrong way of backtesting, your results will be flawed and useless