Whether you’re implementing a new trading strategy or an automated trading system, learning to backtest your trading strategy would ensure the safety of your money.
I always tell traders that the fastest way to lose your trading equity or capital would be to implement a new strategy or robot without actual backtesting.
But there is hope. Because I am just about to show you how to paper backtest a forex strategy.
So, let’s dive in.
Thankfully I have also made a video tutorial so you can learn this easily. I think everyone would prefer learning via video.
What is Backtesting?
Backtesting Definition: Backtesting is a way of determining how well a strategy or model would have performed over a period of time.
Backtesting is a method of determining the effectiveness of a trading strategy by analyzing how it would perform in the real world using historical data.
Think of it like this; imagine you wanted to buy a product you haven’t used before and you’re really skeptical about how effective it might be, wouldn’t you ask around about its past performance?
Let’s say you’re going for a new car; the smart move would be to ask around and research people who have used the car in order to know whether it’s a good buy or not.
It’s the same ideology when implementing a new trading strategy.
You have to investigate and examine how effective the strategy would have been if it was implemented.
If the result of the investigation or backtest is favorable i.e., effective to a reasonable degree or percent, then it proves that the strategy is effective and good to implement on a trading software or platform.
Types of BackTesting
There are two types of backtesting:
- Paper backtest or manual backtest
- Automated trading backtest or robot/ EA backtest
Paper backtesting implies the manual use of a paper, notepad, excel sheet, and basically, any other manual data-recording method to check, examine, analyze and keep a record of the past performance of a strategy over a period of time, IF implemented
The other type of Backtesting will require that you convert your trading strategy into a robot or expert advisor and use a computer program to run the backtest. Usually MT4 or MT5 trading platforms.
How to Back Test Trading Strategy – Manual Backtest
Knowing how to manually backtest a trading strategy is actually quite easy.
The only setback is that its time consuming and cumbersome which is why most people just rather automate the whole trading process.
That way when you want to back-test an automated trading strategy, it’ll be relatively seamless and in fact more accurate.
Meanwhile, Paper backtesting is an easy process and can be done in a few steps.
You just have to understand the rules of the strategy you want to implement and then examine how it would have performed in the past.
let’s create a random strategy:
Let’s assume the rule of the strategy says when the yellow line of the 5-moving average crosses the pink line of the 20-moving average in an upwards direction, we want to enter for a buy and vice versa
You carry a paper or manual backtest out by scrolling going back in time and looking at all the places the price action meets the requirement of your strategy and document or record whether it would have been a profit or a loss.
In the image above, the demarcations market red contains areas where the market or price action obeyed the rules of our strategy.
The areas that contain points depict the number of pips I would have acquired.
From here on out I would want to implement the strategy.
This is a record of what the paper backtest would look like when recorded on a notepad.
Other Important Read:
1. Choose the market you wish to backtest and scroll all the way back to the beginning.
2. On your chart, draw out the relevant indicators.
3. Examine your chart to see if there is any setup that obeys the rules of your strategy.
4. If there is, make a note of your entry, stop loss, and profit target, as well as the trade’s outcome.
5. Repeat steps 3–5 as needed.
Now, for a more in-depth explanation, watch the video below…
- No Need For Coding/programming
- It’s Costless
The disadvantages include:
- It is tiresome.
- When tracking your performance, it’s easy to make mistakes.
- There is only limited historical data available.
Conclusion – Back Test Trading strategy
Indeed, Backtesting is easy, efficient, and absolute for huge sets of data.
While a paper backtest might take weeks to examine and investigate, it is important nonetheless.
Manual or paper backtest is mostly carried out with the use of excel or notepad. It is done by analyzing and documenting the possible past performance of a trading strategy.
Look at this video for clarity!
The ideal paper backtest selects sample data from a relevant time period that spans a range of market situations. This allows you to determine whether the backtest results are a fluke or represent solid trading!
I’ve created a youtube video that shows how to backtest on MT4.