How to Backtest a Strategy in FOREX

Investors use indicators, charts and past data to back test a Forex trading strategy.
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Investors can profit on the changes in foreign currency prices through a Forex account. Forex is the world’s largest financial market and offers investors many advantages, including low trading costs, low entry costs and 24-hour trading options. To manage their Forex trades, investors will often follow strategies that instruct them on the best buying and selling opportunities. Before following a strategy, Forex traders will back test them against past results in order to judge how the strategy may perform in the future.

Forex Strategies

Forex investors often use trading strategies to guide and discipline their investment choices. One reason investors trade Forex is because many accounts let investors borrow money, called “leverage” or “margin.” This advantage lets investors make trades that are larger than their account balance, which can lead to bigger profits. However, this can also wipe out an account if a currency value drops rapidly. Without an investment strategy that sets clear conditions for buying and selling, Forex traders can be caught off-guard when the currency value changes.

Forex Indicators

Forex strategies include a currency pair, a time frame and a set of indicators, which is a measurement that tracks some aspect of a currency’s fiscal performance. Some strategies are designed for specific currency pairs and time frames, while others can be applied to any currency or time period. Indicators show when it's time to buy into a currency pair or an exit point for when it's time to sell. The “moving average” shows price trends by smoothing out price changes over a given period of time. The relative strength index gives investors information about the speed and size of price changes. Stop-and-reverse, or SAR, indicators are measurements designed to predict when the FOREX currency pair’s price is set to reverse directions.

Forex Charts

Investors can back-test their Forex strategies through trading software or by manually reviewing past data and keeping track of when price indicators signal buying and selling. Investors that use trading software to back-test can set their indicators against Forex pricing charts. Forex candlestick charts show investors with one graphic a Forex currency pair’s price fluctuations throughout a period of time, which can range from minutes to days. The candlestick bar marks where the currency price opens and closes as well as the price high and lows.

Back-Testing Process

Whether through software or through manual back-testing, an investor sets a time frame over which to evaluate the Forex currency pair’s performance. If the Forex trader is testing a three-month strategy for a specific currency pair, he would begin the test with historical pricing data from a date three months ago. Then, the trader would follow the day-to-day price changes in the currency price, watching for points where the indicators show buying and selling opportunities. By tracking the currency’s price at these points, an investor can get an idea of whether the Forex strategy will be successful. However, investment advisors note that back-tests aren’t completely reliable, as past performance isn’t necessarily an indicator of future results.

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