What is Backtesting in Forex

10/19/2022 at 11:02AM

Modern-day traders are techno-savvy, as they get numerous resources to learn to trade and execute their trades online. However, jumping into the game without knowing the rules is not advisable. Understanding the ins and outs of market analysis will help you gain confidence and make informed forex trading decisions.

Aspiring traders and beginners must have come across 'forex backtesting' and be curious about how to do forex backtesting. If you wish to deep-dive into this effective forex trading learning method, you are in the right place. This article takes you through various technical aspects of forex backtesting.

What is Forex Backtesting?

Forex backtesting involves testing a trading strategy on historical forex data to gauge its probable performance in the past. The exercise helps you understand how the trading strategy would have worked. 

If you observe that the trading strategy works for the historical data, you can then plan to apply it to real-time trading scenarios. For safer and more informed trading, you can look over the trading strategy's market entry and exit points. 

Similarly, forex backtesting helps you analyse the risk management aspects of your trading journey and is an essential element in building a trading system. Before going further, let's understand the most significant facets required for forex backtesting.

Most Important Requirements for Forex Backtesting

Knowing the most crucial requirements for this process is vital. Let's discuss the two most important needs:

Accurate and Reliable Historical Forex Data

Historical forex data is the record of price movements that occurred in the past. Notably, in the absence of a central exchange, it is challenging to source accurate data from multiple over-the-counter (OTC) entities, like reputed banks, financial institutions, and broker-dealer networks. 

As you need to test a trading strategy on historical forex data, working with a reliable data vendor like us becomes essential. We source historical forex data from the abovementioned sources and bring it in a single, easy-to-use format by aggregating it. 

Forex Trading Strategy

It would help if you determined the market entry, exit, and associated risks. A trading strategy governs these factors through a regulated arrangement. Many commonly used trading strategies consider market trends, mathematical modelling, and other parameters. Traders and analysts should try to decide:

  • The price point to open a new position in the live market - The market entry
  • An ideal instance to close a trading position (the market exit) to earn profit or avoid loss.
Importance of Bid and Ask Prices

The bid defines the highest price of a currency you can sell, while the ask is the lowest price you can buy. These rates help you understand how currency trading occurs in the forex market. Notably, you get clarity about the transaction cost by considering bid-ask prices, and the mid prices only won't provide the exact transaction costs. TraderMade provides free historical data API to test your strategy, simply signup for a free monthly plan.

Pros and Cons of Forex Backtesting

Along with the benefits of backtesting in forex, you should also be aware of its limitations. Weighing both sides of the coin will improve your decision-making process and help you understand the situation better. 

Pros
Scenario Testing

Forex backtesting helps you quickly verify the performance of a trading strategy for different scenarios. For instance, any significant policy change announcements or actions by central banks affect currency prices. It is also cost-effective to check if the trading strategy consistently works on different historical datasets. As you realise that the trading strategy benefits, you can make more informed trading decisions in the live forex trading scenario.

Stress Testing 

Forex backtesting provides you with opportunities to assess the performance of a trading strategy in low and high market volatility. It is vital if you trade with a leveraged account, and it is subject to margin calls if your equity drops below a certain level. Considering volatility is crucial as you must keep it as low as possible.

More than half of the trades occur by leveraging algorithmic trading. An algorithmic trading platform's success relies on the product developers' expertise. Forex backtesting is a crucial element that helps develop forex backtesting software or applications.

Cons
Over-optimisation

Sometimes, traders try to 'customise' the trading strategy while backtesting to obtain the best possible returns. However, applying to real-time trading space may not get similar results. Market conditions keep changing, and 'manipulating' a trading strategy per a particular market condition in history may not work in real-time trading. 

The Complexity of Strategy: Misleading Results

Backtesting on different timeframes and multiple currency pairs may be time-consuming and increase the trading strategy's complexity. Sometimes, you may spend much time realising that an approach doesn't work. 

The more the backtesting is, the better for proper understanding. However, too much analysis may make the strategy unnecessarily complex and unrealistic for real-world trading. 

Thorough backtesting to build better strategies depends upon the quality of the forex data you test it on. Accurate, unbiased, and reliable forex data from us ensures that your backtesting activity will bring out fruitful results in terms of better trading strategies for your live trading. 

Automated Forex Backtesting

Automated forex Backtesting is gaining popularity, and many trading platforms offer well-designed trading wizards. You can also obtain forex backtesting software from third-party vendors. You can create a trading model by leveraging technical indicators to set your rules, and it saves you valuable time and helps you screen the historical data sets faster.

Developers and analysts can automate forex backtesting using Python and also features of Excel. If you wish to learn how to automate forex backtesting, please refer to our detailed tutorials on Python and Excel. 

Backtesting & Forward Testing

You can analyse the market through a critical perspective using backtesting methods. Forex trading experts consider it a significant beginning to draw strategies and trading systems. However, it is not the only type of market analysis. You analyse the market behaviour in the past to anticipate similar price movements. Considering the current market trends is equally important to make informed trading decisions. Forward testing, also known as 'out of sample testing,' involves applying strategy parameters to the live market. 

It is advisable to leverage a trading simulator and a demo account to conduct such activities. Experts combine backtesting and forward testing for a comprehensive determination of trading strategy.

Conclusion

This guide covers various technical aspects of forex backtesting. We hope the information helps you analyse the historical data effectively to test your trading strategies. We have been the most trusted forex data vendor for decades, and our customers rely on us for curated and accurate historical forex data. Quality FX data lies at the very heart of obtaining an accurate trading strategy. You can obtain historical forex and CFD data down to the tick from us in various formats for your backtesting projects.

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