Understand The Limitations Of Forex Backtesting When Evaluating A Trading Strategy

Validating trading strategies by the use of back testing is a popular activity carried out by a Forex trader. It is particularly popular among technical traders, because repeating price patterns in the market form the basic principle of technical analysis on which so many trading strategies are based.

Forex back testing is used to seek validation of how a test strategy is likely to perform when used in a live market environment. Essentially it provides a yardstick of performance. The theory is that if a strategy has performed well in past markets then it will continue to do so in future markets.

Why Is Forex Backtesting Popular?

The back testing of system strategies proves popular with traders for two main reasons.

Firstly the available data needed to carry out the testing is easy to acquire with the testing process itself being relatively easy to perform. Many of the leading charting packages such as Metatrader and Trade Station facilitate strategy testing in just a few clicks. The resultant output provides a comprehensive statement of the historic performance of the strategy. This will commonly include a breakdown on the profit and loss ratio of the trades taken, the number of winning/ losing trades by direction (long and short) and the all important draw down levels on the account.

Secondly, and most importantly, it provides a foundation with which traders can quickly make a judgment call on the success or failure of a strategy. Often the strategy is repeatedly run through the testing process in order to find the highest level of performance. Changes made to the strategy s may include adding or removing technical validations or simply moving profit targets or stop loss levels. The ultimate aim here of course is to increase the profitability of the strategy.

The Limitations of Backtesting

However it is important to remember that back testing is can only ever validate how a strategy performed against historical market prices. It can make no prediction of whether the strategy will work either in current or future markets.

The central flaw of this method is that it assumes that markets will always behave in a similar manner. However the dynamics of the market are constantly changing.

For the trader this poses a problem. A strategy that has worked well in the past may start to falter or fail completely when traded live. Similarly a strategy that produces poor historical results may suddenly spring into life when traded on an account.

It is perhaps more important to gain an understanding of the conditions of the market over the period that the back test was run than the actual results themselves. For example if your strategy back test was run over a period of strong trending markets and the current market was ranging, it would be wrong to expect a trend following strategy to perform.

However even after applying some basic due diligence on the markets, this still does not account for the random events which occur in markets. Unexpected risks are ever present in the market and are likely to bear little correlation to unexpected events of the past. The recent credit crisis for example, has made currency markets more volatile and this trend is expected to continue for the foreseeable future. It is therefore only to be expected that any strategy employed may need to be changed to accommodate these new market dynamics.

The Traders Threat

A further area that is generally never factored into back tested results is the trader himself. This is because back testing assumes that the trader will always act upon the strategy in a uniform way. Even in the case of automated systems, there is no guarantee that the trader will not change parameters or interfere with running positions.

The trader himself is one of the biggest variables to the success or failure of a strategy and the fundamental element that back testing cannot account for.

Many traders become so preoccupied with Forex back testing and refining systems that they never actually get around to trading. This means they never actually ‘cut their teeth’ in the markets. It’s a bit like training for a marathon without ever experiencing the exhilaration of running it. And of course all anyone who back tests can do is validate hypothetical profits and losses from historical market situations. And of course the likelihood is that these will never be repeated.

The only concrete way to evaluate a strategy is by measuring actual strategy performance. And by this we mean in a live environment. While this may fill many comers to Forex with dread it does not have to be a costly mistake. Trading with small lots and sensible leverage means that a strategy can be evaluated with a minimal account size. Only once you are confident should you increase your stakes.

By approaching strategy testing in this way, not only will you reach a much more credible evaluation of the strategy, you will learn a lot more about real trading as well.

Top of Forex Backtesting