Every trader needs to backtest a trading strategy before implementing it in live markets. Without a doubt, an effective automated backtesting system will help you enter the markets with a tested and successful trading strategy without risking your capital.
To help you understand how backtesting works, on this page, we’ll explain what you need to know before you define your forex strategy. We’ll also show you how to back-test forex trading strategies with five easy steps to follow.
- First, What is Backtesting in Forex Trading?
- Why Is It Important to Backtest Forex Trading Strategies?
- How to Backtest Forex Trading Strategies – Step-by-Step Guide
- How to Backtest Forex Trading Strategy on Metatrader 4 (VIDEO)
- Top 6 Golden Rules for Backtesting Your Trading Strategy
- The Bottom Line
- Frequently Asked Questions (FAQs)
First, What is Backtesting in Forex Trading?
Backtesting in trading is simulating the process of trading while using a set of rules over previous price data to see how much money would have been made or lost if a trader had followed the same strategy.
Backtesting is essentially a retroactive test where a trader enters a set of rules like a currency pair, timeframe, and technical indicators. Then, the automated backtesting trading system can analyze the tick data and show what would have happened if you had taken the chosen strategy.
There are three ways in which you can backtest your forex strategies: manual, automated, or coded, and replay backtesting. Either way, all methods have the same goal and principle – to help a trader find out whether the strategy is profitable.
For forex traders, automated and manual backtesting evaluates the effectiveness of a trading system before implementing it in the live markets and risking real capital. Moreover, it gives forex traders the confidence to stick to it when their strategy does not appear to be working (while others doubt their strategy, especially during a drawdown).
Why Is It Important to Backtest Forex Trading Strategies?
Did you know that 78% of traders don’t backtest their trading strategy? And did you know that this is one of the main reasons why most traders fail? And it makes sense, right?
So, calling backtesting anything less than necessary would be an understatement. Like any other action in life, you would want to test your forex trading strategy in a demo account mode before you apply it in the forex market. Knowing how to backtest a trading strategy will simply help you improve your future performance when trading CFDs and forex.
Backtesting is absolutely crucial for your long-term trading success, especially if you are a beginner forex trader. Only through backtesting can one learn the ins and outs of their strategy, find out which forex trading strategies are profitable, and eliminate those doomed to fail. And at the end of the day, nobody wants to be chasing shadows in the market.
The idea of backtesting is pretty simple – if a particular strategy has proved profitable over past market conditions, it will likely be profitable in the long run. By testing a trading strategy, you can know beforehand the profit probability, risks, and the right market conditions for the chosen strategy.
How to Backtest Forex Trading Strategies in 5 Effective Steps
Now, you obviously want to know how to backtest your trading strategy before you utilize it in live markets. Below, we’ll show five easy steps you need to follow to replay backtest your trading strategy on the MetaTrader trading platform.
Step 1: Set the Parameters
First, you need to open the strategy tester in the MT4 trading platform. You can do it by clicking Ctrl+R and the feature will automatically open up. Otherwise, you can navigate to View and scroll down to Strategy Tester.
Next, define the currency pair, the time frame, and the period you want to use. We have attached a screenshot for you to see what it looks like.
Step 2: Access Previous Data
Next, you will access your previous data with the option to download them.
Step 3: Add Your Technical Analysis Indicators
Next up, add your trading indicators. All you need to do is select “Add Indicator” and choose the ones you want to use for your trading strategy.
Step 4: Start Backtesting Historical Data
Lastly, select the suitable timeframes and click “Start Test”. As shown in the image below, all historical data will play back on your screen.
Note that you can pause, rewind and fast forward to reach a point where your backtesting strategy would indicate a trade. Once done, enter a dummy trade with stop loss and take profit levels. This will create forward testing and will help you get the future results of your tested trading strategy.
Step 5: Get a Synopsis of the Results
After the test is completed, the MT4 forex strategy tester will give you a synopsis of the results. It will look similar to this.
The MT4 backtesting automated trading system will also provide a detailed breakdown with the option to paste it into your own spreadsheet. As you can see in the image above, the free backtesting software scanned the strategy in 431 days and executed 25 trades. 17 of the trades are profitable while 8 of them are losing trades. Overall, the strategy has generated a net profit of 720.07 USD with a profit probability of 68%.
How to Backtest Your Forex Trading Strategy On Metatrader 4 (VIDEO)
Check our detailed video on how to backtest your Forex trading strategy on Metatrader 4 (MT4).
Top 6 Golden Rules for Backtesting Your Trading Strategy
Here are six critical tips you must follow to ensure the success of backtesting your trading strategy:
- DO NOT cheat. The automated backtesting trading system
- works to tell you whether something works or not. It is not there to prove your strategy is bulletproof.
- DO define your strategy as tightly as you can. If necessary, create a trading plan and use proper risk management tools before you start the backtesting process.
- DO NOT take one test as gospel truth. It takes a couple of trials to get it right!
- DO take your time with the analysis and include the trading costs. There is no rush!
- DO NOT be afraid to change the strategy and start again from the beginning. Even the best forex traders don’t get it right the first time!
The Bottom Line
Make no mistake; backtesting is not a guarantee of success in trading the financial markets. Some might even claim that backtesting doesn’t work for several reasons. For example, many traders unconsciously try to define a retroactive model that will work for them. But, then, in other market conditions, the same strategy might not work.
However, despite all the flaws of backtesting, learning how to backtest your trading strategy correctly can significantly help you optimize your success and gain confidence in your trading strategy before you implement it in live forex markets. Do not avoid it. It is a simple and effective tool you should implement before you activate a trading strategy in the live forex market.
Frequently Asked Questions (FAQs)
Here are some of the most frequently asked questions about backtesting a forex trading strategy:
Does backtesting a trading strategy work?
Yes, backtesting works for one simple reason – it enables you to backtest a trading strategy before you risk your money in live markets. The idea is straightforward; you use past performance price data to determine whether a particular trading strategy is successful or not.
Backtesting will not help you develop a strategy but rather find one that is proven successful. Having said that, you must backtest a strategy several times before you apply it in the live market. This is a crucial factor for the effectiveness of backtesting.
How do you backtest a trading strategy on MetaTrader4?
There are different methods to backtest trading strategies on MT4. The first and most recommended method is to use the strategy tester tool on a risk-free paper trading account. It is a built-in feature of MT4 and is simple to use (To backtest your trading strategy using the strategy tester, follow our step-by-step instructions above).
Another way is to use the Forex Tester, which is dedicated software for backtesting automated and manual trading strategies. Take note that you first need to download the ForexTester 5, and then you can migrate the Forex Tester data to MT4. Note that there is a paid version; however, Forex Tester is a free Forex backtesting software.
What is the best period to backtest a trading strategy?
Generally, it depends on the type of your trading style and the periods you plan to hold your positions for. For example, if you are a long-term trader, then you better backtest your strategy for a period of 5-15 years. Otherwise, short-term traders can use shorter time frames of weeks or months.