Forex Backtesting – A Beginner’s Guide

What is Forex trading?

Forex trading is the act of trading currencies in anticipation of profits. It takes place in the Forex market, which is the most liquid financial market in the world with an average daily trading volume of nearly $7.5 trillion.

What is Forex trading strategy backtesting?

Forex trading strategy backtesting is the act of trying out a proprietary Forex strategy on historical data to see if it would turn out to be profitable under real market conditions. The main motivation behind it is to confirm the accuracy of the strategy on real-market data.

Why is it important to backtest your Forex trading strategy?

Backtesting a Forex trading strategy is generally advisable, mainly because it offers the following benefits

Helps traders assess the accuracy of a strategy – With a big enough data set, backtesting results can provide a considerable insight into the accuracy level and profitability of a strategy. Knowing the same, traders can decide on other key factors such as the risk-reward ratio and position sizing.

Helps identify the weaknesses of a strategy – Because backtesting happens on actual market data, it can pinpoint the exact shortcomings of the strategy if it were to be applied in the live markets. For example, the strategy may be vulnerable to overtrading. With this insight, traders can work upon the strategy by introducing additional confirmatory signals, and increase the chances of their success.

Helps in strategy optimization – Using backtesting, traders can perform trial and error analysis to judge if the overall success of the strategy can be improved if certain parameters were adjusted, such as the entry or exit levels. As a result, the overall optimization of strategy can be facilitated to a great extent.

Increases confidence – With enough number of trials, traders gain sufficient confidence to back their strategy in times of market turbulence. So, backtesting also provides a sense of comfort in terms of trading psychology.

How to backtest your forex trading strategy

Here’s a step-by-step guide to backtesting your Forex trading strategy

Step 1 – Choose a backtesting platform

The first and most crucial step in the process is selecting the right backtesting platform. For this, you can consider various platforms that offer unique features. Popular options include MetaTrader, TradingView, and NinjaTrader. It's important to ensure that the platform aligns with the specific requirements of your trading strategy.

For our guide, we will use the MetaTrader 4 strategy tester. You can open it from the “View” tab. Alternatively, you can also open it using “Ctrl + R”.

Step 2 – Select the Appropriate Data Range

Obtaining high-quality historical data is a must for obtaining accurate background test results. The amount of data you choose should cover a significant period of time, allowing you to evaluate how your system performs under different market conditions. High-quality information helps in avoiding skewed or inaccurate results.

Step 3 – Set your Backtesting Parameters

Before you start backtesting, you need to establish and define the parameters of your workflow. The objective is to replicate your strategy as closely as possible to real trading conditions.

In most backtesting platforms, you are likely to encounter the following input requirements

• Timeline – A timeline for analyzing a process, providing insight into its business performance over a specific period of time.

• Data sample frequency – The frequency of the test data, whether daily, weekly, or monthly. This criterion sheds light on the adaptability of the methodology to different time periods.

• Trading costs – Trading costs, including commissions and slippage, represent the financial considerations associated with the strategy. Careful analysis of these costs on the end result can tell you whether your strategy is actually profitable after operational costs.

• Position sizing – This refers to the number of positions taken by the system, which is fundamental in risk management and portfolio optimization. Prudent positioning is key to striking a balance between capital preservation and growth.

• Market Exposure – The degree of exposure to different segments of the market, indicating the strategy's sensitivity to various market conditions and sectors.

• Volatility – The dispersion of returns on the portfolio, offering insights into the potential fluctuation in value. Understanding volatility is crucial for assessing the strategy's stability and risk tolerance.

• Stop-loss and levels to take profit – A pre-defined limit at which a strategy starts from a position, either to minimize losses or to make a profit. These layers are an important tool for protecting the division from adverse market developments.

• Risk management strategies – A variety of strategies for mitigating and controlling risk. Effective risk management is essential to maintain program flexibility in different market conditions.

Step 4 – Run Backtest

Perform the page test in your chosen platform. The platform will carry out trading based on the rules of your strategy and the historical data you choose. This step provides you with a sampling performance of your system over the selected period of time.

Step 5 – Analyze the Results

Following the completion of the backtest, it's essential to conduct a thorough analysis of the results. Pay close attention to key metrics such as profit and loss (P&L), maximum drawdown, win rate, and risk-reward ratio. These metrics offer valuable insights into your strategy's effectiveness and its potential for generating profits. Additionally, consider creating visual representations of your strategy's performance through charts and graphs. Visual analysis can assist you in identifying trends and patterns in your strategy's performance.

In MT4, you can go to the “Backtest” tab to get access to a summary of results once the backtest is done.

Types of backtesting

Experts have now reviewed the different variations in backtesting for your reference

Automated backtesting

Automated backtesting is a technique for evaluating the performance of a trading system by employing specialized tools or software, typically in the form of Expert Advisors (EAs) on trading platforms like MetaTrader 4. This approach entails establishing criteria and specific rules within a backtesting tool to construct an objective framework for a thorough and systematic assessment.

Objective criteria
Traders enter standard criteria and rules into the back-testing tool, and define the criteria for their trading strategy.

Accuracy
Automated surface testing allows for human intervention, providing accurate and unbiased results. It does a good job of dealing with a lot of historical information.

Tools
Common automated backchecking tools include MetaTrader 4 and Forex Tester. These platforms enable users to simulate trading scenarios and analyze strategy.

Process

• Insert EA into the MQL4 folder.

• Update the ES.

• Use Strategy Tester in MT4 for background testing.

• See the results in more detail, including reports and photos.

Limitations
Data quality is important, and some tools, such as MT4, may have limitations on usability and advanced features.

Manual backtesting

It is a manual process where the trader visually analyzes historical data, and identifies and executes trades based on pre-defined rules. It provides a more nuanced understanding of market conditions but a challenge of human discrimination occurs.

Objective Criteria
Like automated backchecking, manual backchecking requires traders to establish specific rules for their processes, reducing subjective influence.

Intervention
Traders manually analyze historical data, identify potential trades, and execute them based on established rules.

Tools
TradingView is a widely used platform for manual backtesting due to its user-friendly interface.

Process

• Open the currency pair for testing.

• Utilize the bar replay tool to navigate to the desired starting point.

• Play the chart, pausing when a trading opportunity arises, and execute the trade.

• Journal the outcome and repeat the process.

Limitations
Human bias poses a significant challenge in manual backtesting, as traders may subconsciously avoid losses or justify trades differently.

Importance of backtesting

Experts often emphasize the importance of backtesting for any trader as it helps them analyze how their strategies will perform under different circumstances, providing a clear picture of strengths and weaknesses. It also helps them in the following

• Assess strategy performance – Backtesting provides an objective evaluation of your trading strategy's historical performance. It reveals profitability, win rates, and drawdowns under various market conditions.

• Identify weaknesses – Analyzing backtest results helps pinpoint weaknesses or flaws in your strategy, enabling necessary adjustments for improved performance.

• Build confidence – Positive historical results instill confidence in your strategy, offering evidence of its effectiveness and suitability for real-money trading.

Best Forex brokers

1

9.4/10

Go to broker

eToro is a multi-asset investment platform. The value of your investments may go up or down. Your capital is at risk. Don’t invest unless you’re prepared to lose all the money you invest.

Minimum deposit:

$50

Bonus for deposit:

0%

Regulation:

CySEC, FCA, ASIC

Review

The eToro broker was founded in 2007. The company promotes itself as a social trading platform working with traders from over 140 countries. The broker has several divisions operating under different jurisdictions and licensed by different regulators. For example, eToro (Europe) is licensed by the Cypriot regulator CySEC (109/10) and eToro (UK) is licensed by the British regulator FCA (583263). The broker also has a representative office in Australia and the USA. eToro Profile Details

Pros/Cons

•the minimum transaction amount for copying is $1;

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•it is possible to purchase contracts for fractional shares (that is, to invest amounts less than the cost of one share);

•it is possible to buy shares at once (not CFDs) on the US stock exchanges.

•high spreads;

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•there is a commission for withdrawing funds;

•impolite support staff;

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Study Review

2

9.2/10

Go to broker

Your capital is at risk.

Minimum deposit:

No minimum

Bonus for deposit:

0%

Regulation:

FSC (BVI), ASIC, IIROC, FCA, CFTC, NFA

Review

The name OANDA is an acronym for “Olsen & Associates” or “Olsen AND Associates”. It is registered in the United States and provides its clients with a wide range of financial services in most countries of the world. The company was founded in 1996 and is currently regulated in four jurisdictions. The main regulator of the broker is the UK Financial Conduct Authority (FCA). Oanda Canada is licensed by IIROC. The company has several significant awards to its credit, including a victory in the category "Best Forex Trading Technologies" from the UK Forex Awards, "Best Trading Platform" from FX Week, as well as "Best Customer Service" from the US Foreign Exchange Report.

Pros/Cons

•Minimum deposit from 1 dollar.

•A large selection of the most popular trading instruments.

•Several reliable and reputable financial regulators.

•Inconvenient and poorly functioning site.

•Lack of cent accounts.

•Lack of bonus programs.

Study Review

Tips and tricks for backtesting your Forex trading strategy

Experts have broken down this section into three aspects

Manual backtesting

• Define clear rules – Establish well-defined rules covering entry/exit signals, position sizing, and risk management before initiating the backtesting process.

• Testing multiple time frames – Testing your strategy on different timeframes can help you identify the optimal time frame for your strategy. It can also help you determine if your strategy is sensitive to changes in market conditions.

• Select relevant data – Choose historical data accurately reflecting the intended market conditions, considering factors like time frame, currency pairs, and significant events.

• Use quality backtesting software – Utilize professional software offering data integrity checks, realistic trade simulations, and performance metrics for accurate and reliable tests.

• Leveraging multiple data sources – Incorporating diverse data sources into your marketing strategy analysis is a recommended approach. It allows you to judge both the strengths and weaknesses of your strategy, providing insights into its overall application under various market conditions.

• Account for slippage and commission – Include slippage and commission costs to obtain a more realistic view of your strategy's performance. If this step is avoided, chances are that a profitable strategy (as per backtests) might result in a net-loss position when applied in live markets.

• Avoid over-optimization – Strive for a balance between profitability and robustness to prevent overfitting your strategy to historical data.

Tips to enhance backtesting results

• Incorporate realistic market conditions – Introduce factors like market volatility, news events, and economic indicators to assess your strategy's performance in different scenarios.

• Perform out-of-sample testing– Validate strategy robustness with out-of-sample testing using a different set of historical data. If the results are similar, the strategy may be applied in live markets.

• Include walk-forward analysis – The utilization of forward optimization techniques adds a layer of sophistication to your strategy evaluation. This method involves testing your system on a limited historical dataset and subsequently optimizing it based on the results. The aim is to fine-tune parameters and enhance overall performance over time.

Practical and advanced tips

Analysis of backtesting platforms

As per a study done on top backtesting platforms by Barry D. Moore, CFTe, the following is the analysis of various backtesting platforms through their main pros and cons