Back Testing Considerations: Primary Considerations When Back Testing a Trading System

Many forex traders, whether knowingly or not, tend to incorporate a belief that “History repeats itself” into their forex trading systems. Market observers and technical analysts have often found that the overall predictability of human behavior when acting in large groups tends to make this assumption reasonably sound in practice.

Furthermore, perhaps as a result of this idea, one of the key ways of testing a forex trading system is to run it in simulated trading over a historical time series of exchange rate data and see what its results are.This process has come to be known as back testing.

Why Use Back Test Testing?

Many forex traders routinely use back testing to review the performance of their trading systems before they try them out on a live account. This process generally involves taking the trading system’s rules and seeing how the system would have performed had it actually been traded precisely over the price action that was observed in the past.

Back-testing, especially if it is performed over a longer time frame of five to twenty years, can give a trader a head’s up about what behavior they might expect from the trading system when they actually start to trade it on a live account.

Automating and Optimizing Back Testing

Some advanced trading platforms will allow you to automate this back testing process. They can sometimes even optimize the parameters of your trading system.

This optimization might allow you to determine, for example, the parameters for a particular system that will result in maximum profitability and acceptable losses over the time frame chosen for testing.

Factors to Look For When Back Testing

When it comes to what to look for when performing a back test of a trading system under consideration for live trading, a number of key factors should be reviewed.

  • Profitability – Certainly most people tend to focus on the system’s overall profitability, and this is indeed very important to just about anyone trading forex. Basically, if the trading system is not profitable over the long term, then its time to go back to the drawing board!
  • Consistency – You will also want to look not just at the absolute level of profitability, but also at how consistently profits were made by the system over time, assuming of course that it was actually profitable.
  • Percentage of Winners Versus Losers – Another important factor to assess involves the percentage of winning trades versus the percentage of losers. Most people like to feel good about their trading system, and having plenty of winning trades often gives them the additional confidence needed to continue to trade it.
  • Maximum Drawdowns – An additional factor vital to the long term success of a trading system will be whether or not it has an acceptable maximum drawdown over time. This analysis involves making sure that the largest fall in account value from a peak to a trough seen over a certain period of time meets with what you can accept if it occurs again while you are live trading the system.

Issues With Back Testing

Basically, back testing has its flaws, and so back testing results should not be considered indicative of future trading results, since considerable variation can occur.

Furthermore, back testing is certainly no substitute for testing a trading system in a live trading environment – perhaps on a micro account – in order to gain confidence in it.

Nevertheless, back testing can provide a helpful initial review of whether or not a trading system is likely to perform well in practice. As such, it has some value to forex traders seeking to develop a successful trading system.

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Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.