Trading and making profits in the forex market requires a lot of planning and preparation. The preparation phase involves gaining knowledge about the dynamic currency market and understanding the relevant trading concepts. You need theoretical and practical knowledge to succeed in trading because if you don’t know how to apply fundamental as well as technical concepts to actual trading, you won’t be able to get the desired results. The planning phase involves developing a solid strategy that you will stick with while trading in the fast-moving forex market.
In this case, backtesting is an essential step to ensure the viability of your trading system. In this article, you will see how backtesting helps you to trade better and reach your goals.
Role of Trading Strategies and Relevance of Backtesting
Before getting into the basics of backtesting, you need to understand the impact of your strategy on the trading process. Trading Strategy can be defined as a rule-based system that guides and governs all your decisions and actions as a forex trader. It is an action plan that you will be implementing for trading. There are many trading techniques you can follow in the forex market, but choosing the best one requires weighing the pros and cons of each of them with your own skills and weaknesses. Your strategy should align with your personality as a trader in terms of trading style and goals.
Trading is a solo venture for the majority of retail traders. Unlike in a typical office work setting, there is no one to supervise or instruct about the steps or processes. Hence, you are bound to get distracted and deviate from your objectives in the absence of a sound trading plan and disciplined approach. Having a tried-and-tested forex strategy will also allow you to achieve consistency in trading, and if you can combine trading tools with your strategies, then the chances of success become even brighter. This consistency is critical for achieving trading success in the long run. Hence, your plan or strategy should be based on a long-term perspective.
We are on our own for the most part and have to take responsibility for every move we make to gain from the market fluctuations. Just moving in any direction won’t bring any profit, so the strategy should be a route map that clearly states the path and direction we are supposed to take while navigating the volatile currency market. But what if you start trading with a weak strategy, or what if the strategy does not have enough potential to bring the expected results? In that case, you will waste a lot of time, energy and money in the trading process only to get disappointed.
This is why backtesting of strategies is so important, as it gives us a preview of the actual performance and results of a trading system without risking real funds in the first place. You will be using historical market data and see what kind of trading results you can expect if you were to apply your strategy in the past. Using backtesting features, you can carry out this simple process on your chosen trading platform. It can be a manual process if you want some hands-on trading experience, but automation is also possible for those who want to get the results without much effort.
How Does Backtesting Help Assess Your Trading System’s Efficiency and Profitability?
You can think of backtesting as a form of self-assessment, and it is more like testing how prepared you are to face the challenges in forex trading. In demo trading, you will be testing your own skills, whereas backtesting is focused on testing the efficiency of your strategy or trading system. In the case of manual backtesting, you will also get a better understanding of the best methods of analysis that are required for spotting ideal trade setups as well as the technicalities of trading in a real market situation because the price information used for backtesting allows us to interact and engage with actual market situations that were there in the past.
Backtesting is also useful to get familiar with the market conditions as we can see the market cycle repeating in a specific time-based pattern while analysing the historical price data for a longer duration, like the last 10 years or so. This gives you valuable insights into the currency market dynamics and the price trends that tend to happen repeatedly. Using this information, you can assess the efficiency and profitability of your strategy by seeing how much the market has changed over the years. The trading results you get in backtesting will be different in real-time trading if there is a major shift in the market scenario.
However, you can still learn and practise various technical aspects of trading, like the calculation of various metrics for the perfect execution of your strategy. You can also develop an understanding of pip value calculations, which is the basic unit to measure price movements in currency pairs. You can think of pip value as the foundation for forex trading, and using tools like pip calculators in backtesting makes the calculation easier, thus allowing you to focus on trading instead of calculating values.
Perks of Backtesting
- Helps in Enhancing the Performance and Profitability of Your Trading System
The key purpose of backtesting a forex strategy is getting an idea of how the strategy will perform in an actual market scenario and assessing the profitability of your trading system as a whole. You will see potential profits and losses when you backtest with a solid plan while following all the risk management rules. Automated tools like profit calculators can add more precision to your trading decisions. You can check if the strategy is worth trying in a real account based on the overall trading results, which allows you to enhance the performance and maximise the profitability of your trading system.
- Getting Familiar With the Forex World
The forex market has many peculiar features and offers many trading opportunities due to its volatile nature and high liquidity. Those who are new to the forex world need to get familiar with the fast-paced currency market at first so that they don’t get confused or overwhelmed during live trading. Backtesting is just as good as demo trading as it allows you to observe and study the market for different timeframes. This prepares you for live trading as you know how the market moves and lets you choose the best methods to catch good trading opportunities.
- No Exposure to Market Risk
A major benefit of backtesting is that you will get to test your strategies without being exposed to the market risk, which is part and parcel of forex trading. This allows you to trade without fear and stress and can be more like a practice session when done manually. You will still experience the market volatility and its impact on the trading results. But you can still feel at ease that you don’t have to worry about losing real money in the process.
- Time-saving
Demo trading is more time-consuming than backtesting, as you have to wait for the market to move to get the trading results. Although the trades on a demo account are not real, you are still using real-time market data; hence, completing the trading process takes time. But in backtesting, you can simply place a trade and see the results with a few clicks, as the market has already moved in the past, and you don’t have to wait. Hence, it saves a lot of time for traders.
- Practice With Tools
As I mentioned before, you can try backtesting your strategies using different trading tools. You can decide which indicators can be added to the charts to analyse the market situation and other basic to advanced tools that can be utilised to simplify the decision-making process. Selecting the right set of indicators and trading tools is essential to enhance your trading experience and performance. This actually allows you to optimise your strategy and polish your skills before live trading.
Wrap Up
In a nutshell, no trader should rush into live trading without proper backtesting of a strategy. Your trading system will often have shortcomings, and risking real funds without a detailed review and testing will result in costly mistakes. Such mistakes cannot be reversed in live trading; it will be too late to take corrective action. But backtesting makes the process risk-free and faster, allowing you to extract relevant information while experimenting with different techniques easily.
