Testing your forex trading strategies is an important step before you use it in the real markets.
Professional forex traders seldom use a trading strategy without properly testing it. And no, it is not just trading with the strategy on a demo account.
Backtesting in forex is very important that will really show you how good your trading system is.
But knowingly or unknowingly forex traders only give importance to forward testing in forex.
Forex backtesting and forward testing are two completely different ways of testing your trading strategy. Each of these forex testing methods has its own strengths.
Let’s understand the difference between forex backtesting and forward testing. You will also learn the importance of using both backtesting and forward testing.
What is forex backtesting?
Forex backtesting is the process of using a trading strategy on historical forex market data. Depending on how well your historical forex data is, the better the results.
There are many ways to backtest your forex trading strategies.
You may make use of the MT4 strategy tester feature. And you could also use sophisticated backtesting softwares such as forex tester.
We should mention though that back testing a trading strategy does not mean that your forex trading system will work good in the future.
On the contrary, your main purpose to backtesting trading strategies is to understand the performance of your trading system in different market conditions.
Why is backtesting in forex important?
Backtesting in forex is important because it will show you how good or bad your trading system was in the past.
Many traders misunderstand this. They ask, “Why use forex backtesting on historical data in the first place?” The reason is that when you test your forex strategies on past forex data, you will see the strengths and weaknesses in your trading system.
The main importance of historical forex data is that it already has all the market movements in place. For example, during times of crises, the markets become very volatile. These periods cannot be predicted in the future.
But when you use historical data, such scenarios are already present.
There are some who disagree with forex backtesting completely. According to the critics, forex backtesting may:
- Inspire false confidence
- There is no “perfect” forex strategy
- Price action doesn’t replicate itself overtime
From the critics, it is clear why they disagree. And it is partly true.
If you are using forex backtesting to gauge the effectiveness of your trading strategy, you are wrong.
Forex backtesting should not be used to see if you can “make money in forex using the trading strategy.” On the contrary, forex backtesting should be used to understand the following:
- How well did my forex strategy work during certain extreme market conditions?
- Did my forex system alert me to the potential volatility?
- How can I use this knowledge to apply into the forward testing
- How can my backtesting results help me to avoid losing money when something similar happens
There is an element of trading psychology involved with backtesting too. Among the hoards of different articles on trading psychology, this book from Brett N. Steenbarger called Trading Psychology 2.0: From Best Practices to Best Processes (Wiley Trading) is a very good book to read.
Why do traders neglect forex backtesting?
Traders in general neglect to pay much attention to forex backtesting. This is despite many experts and even authoritative books insisting on its importance.
Day traders fail to give forex backtesting its due share because they do not understand its importance. Failing to prioritize forex backtesting may come due to misconceptions.
Surprisingly, traders do not know how to properly backtest their forex trading strategies. Whether one is buying a commercial forex trading system, or using one from a forum, they seldom backtest their strategies.
At best, traders only focus on forward testing. After all, why pay attention to backtesting when you can forward test on a demo account?
But if we go with this argument that forward testing is simple, there are some potential drawbacks, a trader may not realize.
Let’s face it! When you forward test your trading strategies, you will at best test it for a few months.
Depending on when you start forward testing, the results may be different.
For example, if you were to forward test a strategy during the summer periods, you may get different results. This is because the markets are usually quiet around this period.
On the other hand, when you forward test your forex strategies during the first few months or the last months of the year, the results will be different.
Here’s why forex forward testing is not sufficient!
When a trader gets their hands on testing a forex strategy, they usually jump to a forex demo trading account.
A trader will at best spend a few months testing their trading strategy thoroughly. Once it starts to show decent results, they will then start using it on their real accounts.
But there is a problem with this approach.
When you are testing your forex trading strategies over just a few months, you do not account for the different market conditions.
Let’s give you a clear example.
In March 2020, the Coronavirus pandemic played havoc in the markets. Major currency pairs like the EURUSD and USDJPY had extreme volatility.
If someone started backtesting their strategies from June 2020 onward, the results will be very different comparing to when testing in March 2020.
Now what if you were to use a backtesting software to really test your trading system?
The results would be totally different, wouldn’t it?
What do you need to properly backtesting your day trading strategies?
To backtest trading strategies, you will obviously need to have access to a few things.
The most important things you need for properly backtesting your forex trading strategies are:
- Historical data (tick data)
- Your trading system (incl. the indicators you will use)
- A backtesting software or a strategy tester
Importance of historical tick data in forex backtesting
Having access to good historical data is important. This is because, it will determine how good your trading strategy is.
Using tick data is the best because this is the fundamental building block for all forex time frames.
You may use a H1 or one-hour chart timeframe data. But this can be disastrous for you. The reason is that the H1 open/high/low and close are the only prices you will get.
You will not get to see anything below this time frame.
And you know that during the one-hour chart timeframe, there are many ticks or price movements. Therefore, using H1 or for that matter even the M15 time frame data is not good.
Where can I find access and download good forex historical data for free?
Many traders wonder where they can get access to good historical forex data. The interesting answer is that it is right there in front of you.
You can use your MT4 trading platform and access the historical data directly from there. To do this, go to Tools > History Center or press F2.
It opens a window that looks like this.
Make sure to use the 1-minute chart data. In most cases, you will see it greyed out.
You can double-click on the USDJPY 1 Minute chart time frame and wait for the data to be downloaded. Finally, you will see the total records now available on the top part of the MT4 History Center.
Pro tip: After double clicking on the 1 Minute historical forex data, select this and press the Download button.
This will fetch complete forex tick data for you. It may take a few minutes depending on how much data there is. We recommend using a good forex broker. In our case, we find the FXPro forex broker to be good enough.
If you have a real trading account, then it is even better.
What tools can you use for backtesting forex strategies?
There are many forex testing tools, both free and paid. Both have their pros and cons. A paid forex testing software is clearly more advanced. It will show you things in your trading strategy that a free forex testing system may not.
On the other hand, if you are not a professional forex trader, maybe you do not need to know all the advanced information.
At the end, it is up to the forex trader to decide what they want to use. If you ask for our recommendation, we think it is good to use both the free and paid versions. It is like getting a second opinion.
Let’s start with the free forex testing tools first.
MT4 Strategy Tester – Free Forex testing tool
The Metatrader 4 trading platform has its own inbuilt strategy tester. This can be accessed via the main menu, View > Strategy Tester feature.
You can also use the shortkey Ctrl + R
Using this strategy tester, even forex beginners can backtest their trading strategies. You can either select the dropdown to choose the EA or apply the indicators if you are using a manual trading system.
Then, simply select the timeframe you are interested in and start.
You can use the additional settings such as leverage, spread etc, but we will leave that for another article.
Using the visual mode, you can see the signals being triggered on the charts. But this takes a lot of time depending on how far back you start your backtest.
The first step is to uncheck the visual mode to get a general idea. Then after reading the statistics, you can decide if you want to look into how each of the signals were taken.
Forex Tester – Paid Forex Testing Tool
The Forex Tester is a forex backtesting software. You can also use this for trading simulation as well (just as you will trade using a demo account).
This is a professional forex testing software that allows you to do a lot more including AI based strategy optimization.
The Forex Tester software is compatible with the MT4 indicators and expert advisors. Therefore, if you are using a different platform like cTrader, the indicators will have to be converted to MT4 version.
You find MT4 developers resource here who can convert the indicators from one trading system to another.
The forex tester comes with additional features such as allowing you to also back testing the trading strategy visually. This is not available on MT4 strategy tester.
You will now start to see why a professional forex testing software is so important.
Forex Backtesting vs. Forward testing – Conclusion
In conclusion, forex backtesting is important for traders who are serious about their trading.
A backtesting functionality allows traders to expose their trading system to different market conditions. Backtesting in forex is a great way to understand how you trading strategy performed historically. More importantly, you will get to see the different market conditions under which is performed.
With forward testing, you are using the trading strategy on a forex demo trading account. This will mean that the accuracy of your trading strategy is only as good as the duration you have forward tested.
Backtesting in forex is important as it allows you to see hidden flaws in your trading strategy. This is where forex forward testing clearly fails.