Backtesting: The Advocates and Critics

Filed under: Learn Forex Trading |

Screen shot 2013-03-22 at 11.08.52Following on today from my article on optimisation, I would like to talk a little bit more about backtesting, and outline some of the concerns of its critics, and some of the reasons why people advocate backtesting systems.

 

Backtesting (with regards to the forex markets) refers to the analysis of historical price data, and using that historical data to make predictions about the future. So, you might come up with an idea for a system (a hypothesis), and then test that system by analysing what would have happened if you had used that system in the past. The more data you can use, the better the reliability and robustness of the system. Such tests can be done via software such as the ‘strategy tester’ in Metatrader. However, some critics are saying that such backtests are meaningless, and that past data cannot be used to predict future price movements.

 

It is true that human beings, by very nature, see patterns in things. However, past data is the only data that traders have to work with, and as such, it has to be seen as a valuable source of information. If something is happening with great regularity in the past, then there must be a greater chance of the same thing happening again in the future. In this sense, backtesting can be a very useful tool for forex trade system creators.

 

However, it is important not to look at the data and then to choose a whole host of parameters to make that data fit a profitable system. Instead, it is much better to come up with a logical hypothesis, and then to test that hypothesis in a scientific manner – without bias. If you can come up with an idea, and that idea is profitable over a very long series of trades – then you are likely on to a winner.

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