What Is Forex Backtesting and How Does the Past Inform the Present in Trading?

What Is Forex Backtesting and How Does the Past Inform the Present in Trading

Insanity is doing the same thing repeatedly and expecting a different result. Those words are often attributed to Albert Einstein. There are plenty of forex traders out there that have learnt that lesson the hard way – they believe implicitly in their trading strategies and refuse to deviate from them until it’s too late and their bankroll has been wiped out.

If you are struggling to achieve consistent profits when trading the markets, it is imperative that you take the time to study and analyze exactly what has gone wrong. Hindsight is a wonderful thing, and it can truly make a difference to your trading capabilities when you invest the time in backtesting your strategies, see what works and what doesn’t, and understand how you need to proceed in the future.

Happily, the markets offer plenty of learning experiences in themselves – looking at the past movements of the forex market offers huge insight into the future. You’ve just got to take the time to discover why.

History repeating itself

As you are probably aware, there are numerous Forex Chart techniques and indicators that offer a predictive look at how a particular asset is valued now and how that might change in the near future.

And yet, one of the best guides on our trading journey is simply past market movements, with the charts detailing these in glorious technicolor.

You can take a deep dive into the technical analysis and charting instruments, but ultimately the moving averages and candlestick patterns have all been seen before – it’s simply a case of implementing best practice to maximize your returns.

It’s true that life is unpredictable in general, and when trying to understand the future of the forex market, it’s impossible to take into account unforeseeable events like the Covid pandemic, an economic meltdown or two or more countries embroiled in ever-increasing hostilities. All of these ‘macro’ factors can have severe repercussions for forex traders.

We have seen rising levels of inflation before, and there have been many instances where the cost of living has increased in a non-linear fashion when compared to the average salary. We can also plot how a change in interest rates will impact the forex market – there’s stacks of time-served data offering the insight that you need.

What is interesting about the forex market is that there are only three critical factors that impact its performance: supply, demand and market sentiment.

To that end, we can use past market data to predict the future – knowing full well that the combination of the above-named factors is all we need to quantify before entering a buy or sell position.

What is forex backtesting?

To test the quality of our forex trading strategies, we can plug the numbers of previous market data and testing how our systems would perform in similar situations as to now – knowing full well that the past can predict the future in foreign currency trading.

You need to use a strong data sample in your backtesting – ten years or more is ideal if you can get your hands on the necessary numbers, and these will provide fantastic lessons as to what to expect in the current and future forex trends.

Backtesting is particularly useful in planning a response to a major world event, as we can see forex traders acted before in similar situations – and how long it might take for the market to recover.

One of the major mistakes that many forex traders make is to not comprehensively backtest their trading strategies before they enter the market, and any success they have is based purely on luck – giving them the confirmatory bias that they know what they are doing!

And then the market turns against them, leaving them cruelly exposed with lots of capital at risk.

As we have learned in this article, past market trends can be used as predictive tools for the future, and so traders have no excuse not to backtest their systems and strategies in advance of deploying them for real. A lot of systems simply don’t work, but it’s clearly a smart idea to find that out in backtesting or via a demo account with a trading broker.

Don’t forget, Einstein knew a thing or two. Don’t fall into the insanity trap of making the same mistakes time and time again. Backtest your forex trading strategies first and see if they are likely to be successful – with no risk to your capital.

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