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

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.


Most people that do take backtesting seriously do it in a wrong way. So, when they start trading live, they notice the results don’t match. That’s because their backtesting was not done correctly.


Consistently testing your strategy

Consistency is key. If you don’t backtest your forex strategy consistently, your live results won’t be consistent. Always follow the exact same process when backtesting. Always follow the rules and be real with yourself. Is it a winner or not? Keep track of everything and don’t try to do it all at once. Backtest for 1 hour a day. If you do that every day that’s 30 hours a month.


Tweaking & improving

When you have done your basic backtesting, it’s time to answer “what-if” questions. If you do the backtesting manually, which I recommend, then you have probably noticed similarities between winning and losing trades. Come up with what-if questions.


  • What if I place my stop here instead of there?

  • What if my target goes here?

  • What if I manage my trade like this?


Find answers to those questions. Gather the data and see what works best. There is always something to improve. It’s hard work, it might be boring, but it’s worth it.


Tips for backtesting your forex trading strategy


When you are backtesting your forex trading strategy, be sure to have a negative skew. What do I mean by that? If I have backtested a strategy and it performs a certain way, I always correct it with a certain percentage to the downside. Why? Because, strategies can become less profitable. Also, when live trading a strategy you will make mistakes. You want your edge to still be profitable after making mistakes. By decreasing the profitability of a backtest it gives me realistic expectations. If it’s still profitable after that, you probably have found a decent edge.


Another thing to do is to look at the equity graph. How does it look? Smooth? How has it performed recently? Better than past years? See if there is consistency. You don’t want an equity graph that looks very choppy with huge drawdowns. Again, consistency is key.


Test your strategy over different markets. Get enough data. Make sure you have a big sample size. I always aim for at least 5 years, preferably 10 years. But that’s because I swing trade. If you have a day trading strategy that gives you 200 trades a year, just going back for 3 years probably gives you enough data. Also, you could pick different years. So, for example, backtest 2021, 2015, 2009. The markets were different back then and you want to see how your strategy performed during those times as well.


Conclusion


Alright ladies and gentlemen, that’s it. You now know why backtesting is important and how to approach it. You know how manual backtesting works. And yes, you can manually backtest on MT4. So, you probably have work to do. Get started now. Do you have questions? Contact me or comment down below. Do you want a 1-on-1 zoom call with me? Click here.


Serious trader and willing to work with me, 1-on-1? Click here.

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