The Drawbacks Of Back Testing In Forex

If you’re looking to build a profitable forex trading strategy, you’ll probably have been advised to back-test your strategy to gauge the profitability. Whilst this is a brilliant idea, there are some drawbacks most traders overlook. These drawbacks can be the difference between a profitable trading strategy and an unprofitable trading strategy. We’ve spoken to so many traders over the last few years that are incredibly profitable in a back-test but cannot make a profit in live markets.

 In this article, we’ll discuss the drawbacks of back testing that you need to consider when building out your forex trading strategy. So, let’s get into it…

 The Drawbacks Of Back Testing In Forex

 Back testing is one of the most important parts of building out profitable forex trading strategies to execute within the markets. It’s very difficult to become a profitable trader without having thousands of trades under your belt. Typically, this would take many years to obtain – unless you back test and can trade thousands of times on historical data. Back testing really does help to build an edge in the markets and help traders sharpen their sword. However, back testing is often done wrong. We’ve seen so many traders having stellar back testing reports – however, they don’t make a profit in the live markets.

This isn’t just because the markets are constantly changing – it’s usually due to the fact the strategy was never profitable in the first place, it just appeared to be a profitable strategy during the back testing. There are various aspects of backtesting that need to be considered. Let’s discuss them!

Tick Data Accuracy

Undoubtedly, one of the primary issues with back testing is the quality of tick data. If you take a look at most back testing reports generated out of MT4, you’ll see there is a tick modeling quality of 90%. With this level of data, all of your data is utterly useless, and your profitable back test may truly be unprofitable. We’d recommend using at least 99.9% quality tick data to model your back test. However, this is relatively difficult to obtain and typically comes with a price tag. Do bear this in mind when testing and choosing which back testing software you’ll use. 

Human Bias

If you’re testing a manual trading strategy, rather than an automated strategy – human bias will ruin your test data. You’ll miss trades purposely and take trades that you certainly wouldn’t take on your live account. Moreover, emotions will play a giant role in a manual trading strategy and this impact can be catastrophic. You’ll be more than happy to take a trade that doesn’t tick every rule when conducting a back test. However, on a £1,000,000 funded trading account – you might be too cautious to pull the trigger. Or, the other way around, when greed takes over!

Spreads, Slippage, And Commissions

For swing trading and position trading strategies – this is less relevant. However, for intraday traders and scalpers, looking at spreads, slippage, and commission costs is incredibly important. Many traders forget to include these fees in their back test, making their strategies incredibly profitable. However, in live markets when you add in the large broker spreads, large commission fees and slippage on the small pip movements, the strategies rapidly become unprofitable. Most back testing software packages do allow you to set varying spreads, a commission value and a slippage value. Those can provide a much more realistic back test figure and prove the profitability of your strategy before deploying in the live markets.

Curve Fitting

One of the main drawbacks of back testing a forex trading strategy is curve fitting. Once a strategy has been back tested, you’ll likely find plenty of improvements that can be made. For example, your strategy took a massive loss in July, so you rule out trading in July. There are grounds for improving a strategy based on the back test data, we aren’t saying otherwise. However, many traders will make a huge amount of small tweaks to their trading strategy which leads to amazing results in a back test. Although the back test results will be great, you’re essentially fitting a strategy to the historical data. This doesn’t mean it’ll be reflected in the live markets – it just means you’ve modeled it perfectly for your historical data set.

We’ve seen this time and time again where traders have a perfect strategy on paper but in the real live markets, their strategy is wildly less profitable. This is usually down to curve fitting the back test and making hundreds of tweaks – rendering the strategy largely useless within live markets.

Volume Of Trades

Many traders assume that 100 trades is enough of a back test to prove whether a trading strategy is profitable in the forex markets. This is largely untrue, and you realistically need a much larger sample size if you want to trade the strategy with any level of confidence. We’d recommend getting as much data in your sample as possible, within time constraints. Having 100 trades is simply not enough to validate a trading strategy – it may appear profitable, but over 150-1000 trades, it’s actually unprofitable.

Lack Of Emotion

If you’re manually back testing using subjective rules, the emotions at play will be entirely different from the emotions you’ll feel within the live markets. The emotions of fear and greed typically run rampant in the live markets with traders. These are dampened in a back test, meaning your results can be varied from your results in the live markets. These emotions can definitely be handled in the live markets, but it takes time to get to the point you’re relatively emotionless. At Lux Trading Firm, we coach our funded traders to be able to detach from their emotions whilst trading – but this is a skill many traders fail to learn.

So, Should You Back test Your Forex Trading Strategy?

You should still back test trading strategies if you’re serious about becoming a profitable forex trader. Despite all the drawbacks, there is no better way to get your chart hours up and build out an edge than back testing. However, it’s crucial to consider the drawbacks mentioned above and ensure you’re mitigating these during your testing phase. If you ignore even one of the points we’ve discussed, your back test could be entirely incorrect.

In Summary – Is Back Testing A Forex Trading Strategy Pointless?

In conclusion, back testing has a great deal of flaws, but it certainly isn’t pointless. If you approach your testing in the correct way, you can fast-track yourself to becoming a profitable forex trader with a range of profitable strategies.

Are you looking to become a funded forex forex? Work with Lux Trading Firm today!