Forex Backtesting Trading Strategies

When you mention “forex backtesting trading strategies,” especially the manual one, the most traders will either say that they prefer forward testing or the strategy tester feature of MT4, either that they don't need forex backtest since “past performance doesn't guarantee a future result.” But, while it is true that “past performance doesn't guarantee a future result,” backtesting helps traders enhance their future performance:

1. Helps to understand the strategy better

Every strategy begins its life in its' barebone condition. For example: a Simple Moving Average crossover between MA10 and MA30, in which when MA10 crosses MA30 upward signalling buy and downward signalling sell. When backtested properly, any trader will find a series of signals like on the picture below:

Manual Backtesting

AUDUSD M5

Where the brown line signifies Opening level, the gold line shows the supposed direction of a trade, wheras the red and green lines convey the relation between one signal and the next ones (red is a loss and green means gain). As it shown on the picture, out of 9 signals during the period only 3 (three) result in profit – and then one of them is most likely to be a breakeven (due to spread) instead of giving a gain.

Still, it is too early to judge the strategy as a failure. This may be a drawdown situation, which happens from time to time in any strategy. Thus, collecting more data while doing your backtesting you might prove that this strategy does work in the longer run.

On the other hand, it might also mean that this strategy needs some kind of a confirmation to filter out false alarms from the real deal. There are several possibilities for confirmation:

- The price itself, whether the next candle conforms or counters the crossover.
- Another indicator/tool. For example: Pivot point – whether the crossover pairs the Pivot Point or is against it.
- A higher time frame trend. For example (since the above picture is M5) hourly time frame trend. If on H1 the trend is up, then any cross down is considered invalid and vice versa.
- Direction of SMAs. If crosses up when both MA are upward, then the buy signal is valid.
- Whatever setup any trader can think of.

2 Helps optimizing Money Management

Most newbie traders tend to make the most out of their money. But this brings the possibility of loosing all their equity in a single trade.

On the other hand, trading the smallest possible lot simply to preserve equity might not be wise as well. After all, if the result is so low, then doing another kind of business might be better than trading.

By taking the result of forex backtesting trading strategies over a certain period, counting in any drawdown that might happen in between, a trader can adjust his/her money management (thus the lot-sizing) to ensure a better than average result.

3. Helps nurturing a trader's instinct

A trader's instinct, to know when the price reverses, or if the reverse is simply a pullback. Who doesn't want to have such an ability? But there is nothing magical about an instinct. It is nothing but a byproduct of the wonder of human brain.

By doing backtesting manually and studying price movement bar by bar, a trader stores price movement data in his/her brain one after another. When the brains receive enough similar data over a period of time, it automatically sorts them out and tags certain data with certain similarities while discarding the rest. Thus, over time, when a new data enters what a trader sees in his/her chart, if it has a close similarities as the tagged ones, the brain kicks up. As the result, a mentioned trader feels he/she recognized the price movement and its possibilities. Thus the trader has built his/her trader's instinct.

While these doesn't guarantee a solid success since trading is about probabilities, these will sharpen the trader's edge in trading. And having a sharper edge means having a better chance of success.

Forex Backtesting Trading Strategies: Manual Backtesting

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