i. Backtesting means testing a strategy on past price data.
ii. Go through the process of backtesting as if you’re taking the trade in the live market.
iii. Backtesting allows traders to know if the strategy is worth trading or not.
Before you start trading any strategy, you need to backtest it. Backtest simply means to test the strategy to decide if it's good enough or not. Backtesting will also help you know where the strategy lacks and how you should improve on it.
What is Backtesting in forex?
Backtesting in forex is nothing but a term used in trading that in simple words means testing a particular trading system based on historical data.
Backtesting is done to check whether the strategy you are using works well or needs any improvements.
Backtesting may also help you to check the risk to reward of the trades and the drawdown percentage you get using that particular strategy.
How does Backtesting work?
Backtesting helps you to analyze forex charts and generate the results of the strategy you are using based on historical data.
If you are new to forex trading and you purchased a new forex strategy online, let’s say you learned a strategy from the internet.
Directly implementing that strategy on the live market will be no less than a suicide. Backtesting your strategy will help you with understanding it more correctly.
Let's say you learned to trade flag patterns. Now forex market is not a perfect market, and you won’t always get the patterns you learned on the internet or a book.
It will probably be making the same setups you were waiting for, but you may not be able to find it. This is because you are looking for a perfect or more bookish setup. And perfect setups do not exist.
For implementing that strategy, correctly, you will have to get familiar with the forex charts. You should know how and why the forex market moves.
If you backtest your strategy, it will provide you with the experience which one should have before trading the forex market. You will start finding your setups effortlessly.
You will be prepared for every situation that will come your way because you already faced it while backtesting.
Types of Backtesting
There are two ways by which you can backtest your trading system or strategy
1. Manual backtesting
Manual backtesting is a way of testing your trading system manually by using human efforts.
This is the most excellent way of backtesting a trading system due to its various advantages.
I always recommend my students to regularly backtest their strategy as well as the trades they take every week.
This is because this helps them to improve their entries and helps to get comfortable with the trading setup. Manual Backtesting can be done on any trading platform, as it does not require any sort of coding.
2. Automated backtesting
Automated backtesting is a way of testing your trading system with the help of programs or software.
In this, the software will enter and exit a trade on your behalf and will provide you with the total summary.
This type of backtesting has several drawbacks. You cannot backtest every trading strategy. Furthermore, it won’t be providing you with the market experience, which is essential for forex trading.
If you use automated trading software and don’t have time for manual trading, then automated backtesting can be beneficial for you.
There are several automated backtesting software available in the market, but only a few of them are free.
How to Backtest?
There are n number of forex strategies available in the market. Each trader trades using a different strategy.
Some might trade using a price action strategy, and some may be using an indicator-based strategy.
A simple way of backtesting trading is given below.
1. Choose a forex chart on which you want to test your strategy.
2. Now according to your trading style whether you are a scalper or a swing trader, choose the timeframe you usually trade on.
3. The next thing you need to do is to go back at least a year in the chart.
Now from this point, start finding as many setups as possible until the present day.
4. Try to understand what your chart is trying to tell you, how is it reacting to different setups. Understand the formation of your trading setup. For example, if you use channels or flags, then they will not be the same as it is shown in the books or the internet. So, try to find different types of flags and understand their formation.
5. Calculate the drawdown each trading setup gave.
6. Calculate the risk to reward ratio of every setup you spot.
7. Try to understand why a setup worked and why a setup didn’t work.
8. Based on the above points, make some rules for entering a trade and getting out of a trade. Getting out of a trade is as important as getting into a trade, so make sure you always make rules for this.
9. Take notes of the types of setups that work on a specific chart or which setups regularly occur in a particular chart.
This will not only help you with your practice but will also give you confidence while trading on live forex charts.
Backtesting on TradingView
For all MacBook users who cannot install MetaTrader 4, tradingview is an excellent website to analyze as well as backtest your chart.
The trading view comes with a lot of useful tools and indicators, and the best part is that you can use it without even signing up.
Backtesting on tradingview.com can provide you with a live market experience as they provide you with the bar replay option.
In this option, you can select a particular session or day from which you want to backtest your chart.
Steps to backtest on tradingview.com
1. Go to tradingview.com, now go to the charts section and choose a chart of your choice.
2. Select the bar replay option on the top of the screen.
3. A red verticle line will appear on the screen when you move your cursor, move that line to the area from which you have to start backtesting.
4. Now analyze the setups and click on the play button. You can adjust the speed of the bar reply as per your need.
Backtesting using MetaTrader4
Metatrader 4 does not have an option for bar replays.
Manual backtesting on MetaTrader 4 can be done with those nine steps I have mentioned above.
Backtesting weekly/monthly trades
If you are a day trader, then backtesting the trades which you enter in an entire trading week can help you improve your trading.
I backtest each closed trade which I took in a week. This helps me understand how the market played out and what should I expect next.
Backtesting your winning trade will boost your confidence, and you will begin understanding markets deeply.
Backtesting your losing trades may help you with analyzing whatever you did wrong, and you will be able to stop yourself from making the same mistake again.
Benefits of Backtesting
The primary benefit of backtesting is that it boosts the trader's confidence.
If you backtest your strategy, you will have a proper understanding of it, and you will know if your strategy works.
This will help you boost your confidence.
Backtesting may help you get comfortable with your trading system. The more you backtest your strategy, the more comfortable you will get.
Trading comfortably increases your odds of winning the trade by 20% and also keeps emotions out of the trading.
3. Improved entries
As you get going with backtesting your strategy, you will understand your strategy deeply.
And as you practice it while backtesting, it will help you improve your entries.
The goals of backtesting
Backtesting will allow you to do three things.
First, you will be able to identify how suitable the trading system is for you.
Second, you will learn to trust your trading system and also learn to let go of your trades.
And third, you will gain confidence and expertise with your trading system, because you have taken more than a thousand trades while backtesting and know how it works.
1. To determine how suitable is the trading system
The very first goal of backtesting trading is to find out how suitable is your trading system for you.
Does your trading style fit your view of the markets? Does it fit with your understanding of the markets? These little details are essential for you to be profitable.
For example, if you feel the 5 min or 15 min charts are not for you or your setups don’t work on them, then you must avoid it.
Likewise, if you feel a pair, for example, doesn’t fit your style or most of your setups go wrong on this chart, you must avoid trading it.
This not only helps you with avoiding wrong setups but also makes you see the possible setups which are not there yet.
For example, I personally trade a strategy and I know from backtesting and experience that GBPJPY often forms a head and shoulders pattern and that pattern works most of the time.
Since I know this, I am ready to trade based on such setups as when they appear on the charts. This can help a lot in getting consistent profits and avoiding losses.
2. To develop confidence
After you are done finding a suitable trading system that works for you well, you need to develop confidence and get comfortable trading that system.
The key here is to gain expertise in a large range of the market. The more relaxed you are, the more effectively you will be able to manage your trades.
This relaxation will naturally come into you once you are confident about the trading system or strategy you are using.
This confidence will be developed when you backtest your strategy too often, by testing it on the large numbers of setups on various charts.
3. Become an expert
The number one reason forex traders fail is that most forex traders are not experts. Most of them begin trading with very less or no experience.
When any of the setups go wrong, they abandon their trading system, and they fail.
Only an experienced forex trader knows how to overcome or tackle a certain situation because they have experienced and have dealt with this thing before and know how to tackle it.
The only way to become an expert is to practice and spend as much time as possible studying the chart and practicing your trading system.
This will not only help you spot your setups easily but also help you to tackle difficult situations more effectively.
Backtesting trading is an essential aspect of forex trading, and every trader, whether he is a beginner or has experience should consider backtesting forex in order to improve his trading and make consistent profits.