In our post “Where Can You Find a Forex Trading System?”, we gave you some tips for how you can find or build a forex trading method.
The next step after choosing a trading system is to backtest it. If you have never conducted a backtest before, you might not be sure what this process entails or how to get started. We have put together a step-by-step guide to make it easy for you.
1. Choose a method.
First, decide which trading system you want to test. It should be a method that feels intuitive to you and which is likely to fit your schedule, style, and level of experience.
2. Study the method.
Next, study the trading strategy. This involves more than just reading through the rules. You need to understand exactly what constitutes a strong trade setup. You also need to know what substandard setups look like and how to tell them apart from good setups.
That means you need to make yourself an expert in each component of your trading strategy. This by itself is going to involve a lot of scrolling through charts and identifying examples.
Further, you need to learn everything you can about context. Know what market conditions the method is suitable for and which it is not.
3. Create a spreadsheet.
Before you can commence with your test, you need a way to record your results. To that end, you should put together a forex backtest trading spreadsheet.
We suggest columns for the following:
- Buy or sell
- Reason for entry
- Entry price
- Exit price
- Profit or loss amount
- Notes for each trade
You may be tempted to run through your test without the “notes” section. But recording qualitative information about each trade is going to be a huge help in determining the nuances of what works and what doesn’t.
Remember, you are not just checking if the trading system can work. You are learning the best practices for how to make that system work.
4. Choose stats to track and set up formulas in your spreadsheet.
You are going to need a way to analyze all of the information you are recording in the columns of your spreadsheet. That means you need to track statistics.
Here are some stats to consider tracking:
- Number of wins
- Number of losses
- Average win size
- Average loss size
- Net pips
- Win percentage
- Win/loss ratio
- Worst losing streak
- Net wins for each type of setup (if your system involves more than one setup type)
- Your net profit divided by your largest loss
A common newbie mistake with backtesting is to just track one stat. But to get a full picture of what is going on, you need more information.
You can put formulas in your spreadsheet to automatically calculate the stats as you add data to your spreadsheet. That way, you do not have to do the math yourself and you can check the stats continuously as you test.
5. Pick a currency pair and timeframe.
Next, decide what currency pair and timeframe you want to focus on. With some strategies, you might look at more than one timeframe at a time.
Open the applicable charts and set them up to your liking. Add whatever indicators you want to use.
6. Scroll way back in time on your charting software.
Now, scroll back in time. How far back you need to go depends on what timeframe you are trading on and how many trades you expect to take place within a given period of time.
7. Turn off auto-scroll. Look at the very far right of the chart.
Ensure the auto-scroll feature on your chart is switched off so that you will not lose your place as you work. Now, direct your attention to the far right side of the chart
8. Scroll forward a candle at a time, trading on paper as you go.
Move the chart forward a single candle at a time so that you see the price changing just as you would if it were happening in real-time.
Pretend that it is happening in real time. If you see a potential trade setup, do not look further ahead. Instead, figure out where you would enter the trade, and set up a take-profit and stop-loss as well if that is part of your system.
Continue to move the chart forward candle by candle. Exit your trade according to your rules. In some cases, that might mean that you decide to get out early before the price reaches your take-profit or stop loss.
Regardless of your approach, record the outcomes of the trades accurately just as they unfolded. Do not be tempted to give yourself a “redo.” You would not get one in real life.
9. Take detailed notes in your spreadsheet.
As you record the results for the trades, you also should ask yourself questions and make observations about your trading decisions.
Say, for instance, you took an entry that was not quite up to your usual standards. You should take note of that fact. That way, later, you can make sense of why some of your trades may not have turned out the way you expected. You can also find out the effects of loosening or tightening various parameters for your trades.
10. Rinse and repeat.
Once you have finished conducting a backtest, you can run a final analysis of your outcomes and notes. Look for patterns that give you hints for changes you can make to improve the implementation of your strategy or the system rules themselves.
Then, it is time for your next backtest. You may need to repeat backtesting a number of times before you are ready to proceed to the demo.