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How to back test forex trading strategy?

Back testing, ie. going through simulated or historical data to evaluate a trading system is one of the most important things that a trader can do.

There are a multitude of ways to back test a system, so back testing will be done based upon budget most of the time.

The reason the budget comes into the picture is that some large funds have the ability to run simulated trading based on back testing through various market conditions in an automated fashion. Unfortunately, this requires a lot of computing power and financial investment. Because of this, most retail traders do not realise this opportunity is out there, or even if they do, they simply cannot afford it.

Most of the time, retail traders will back test in a much more straightforward manner. By looking at historical data, they will simulate their trading results, by going back and calculating both winners and losers based upon the trading strategy that they are using.

For example, if they have a trading system that is based upon a moving average server, they will simply calculate the entry price, the exit price, and then the profit or loss of that trade. The idea is that over the longer term, they can get a statistical rating on how the system performs over the longer term.

There are various thoughts on how much historical testing you need to do, but quite often people will look at the historical performance of a trading system in blocks of 100 trades. This makes sense, because you can get an idea of the performance based on the success rate, and back testing is absolutely vital.

You need to know that the system you are using is going to work over the longer term, because day-to-day trading produces a lot of widely varying emotions. However, if you know that in the long term this system does produce profits, it is much easier to go through a series of small losses. However, if you don’t know that statistically it works out, you are more likely to switch systems, even if you would have made money over the longer term.

Worse yet, a lot of traders simply jump into the market with live money without knowing what their expected results are. By doing so, you are clearly working at a disadvantage, because you do not have hard data to fall back on.

As many professional traders will tell you, if you do not know what your expected return is, you are simply gambling in the markets.

There is a huge difference between employing a strategy that works over the longer term than to simply buy and sell based upon the latest twitch. This is where the professional and retail trader differs quite drastically, as professional traders keep track of hard data and statistics in order to run their business in a profitable manner. Trading is no different than any other business, and you need to have an idea as to what you can expect and perhaps even what you can project as far as future earnings.

Simply looking at charts and how the market reacts when your system sends a buy or sell signal can give you a major 'heads up' as to how you should perform over time. If you find yourself back testing the system and it doesn’t make money, then you know it’s time to go back to the drawing board. However, by doing it ‘virtually’ in back testing, you save yourself quite a bit of money.

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