The best traders know how to backtest a trading strategy. This means using historical data to create a performance curve - but it doesn’t need to be complicated. In fact, many of the best traders have a very simple approach.
For example, several traders backtest a trading strategy on their funded forex accounts using only one or two time frames and with very few indicators. The key to successful backtesting is to focus on the most important aspects of the strategy, which means spending less time on small details, and more time on the big picture. So - here’s how to do it.
How to Backtest a Trading Strategy
A trading strategy is a set of entry and exit rules you apply to your trades. It takes the guesswork out of trading, making it more likely that you'll place winning trades.
Of course, nothing is 100% guaranteed, so you'll need to monitor your performance and adjust the rules as necessary. But if you follow these rules, you'll be able to make money trading forex consistently.
Once you have a trading strategy in place, it's time to backtest. For this tutorial, we'll use a double top and double bottom trading strategy.
Firstly - what is a double top and double bottom trading strategy? Good question.
The key to success is keeping a trading journal of your trades, backtests and strategies. Here’s how to keep an effective trading log>>
How do you spot a double top and double bottom?
The easiest way is to watch for a sudden shift in momentum. A double top is formed when buyers overwhelm sellers. A double bottom happens when sellers overwhelm buyers.
This strategy works best in strong trending markets, such as the majors. However, it can be applied to any asset where strong trends appear regularly.
Both patterns signal panic and panic can cause traders to sell at the worst possible moment. But panic isn't necessarily a bad thing. Sometimes it's caused by a huge shift in investor psychology, like when investors see total losses mount — a currency plunges amid a global recession, for example.
Other times, panic is caused by a sudden change in investor sentiment. When traders are convinced that a currency's value will fall, they rush to sell, which pushes prices down. These "panic rallies" often lead to more panic.
Double tops and double bottoms are commonly used as entry and exit points for forex traders. When applied to forex, a double bottom pattern shows exhaustion in a downtrend. It indicates a deep retracement and a strong reversal. This pattern is often used as an entry signal.
When applied to an uptrend, a double top pattern shows exhaustion in an uptrend. It indicates a deep retracement and a strong reversal. This pattern is often used as an entry signal.
The double top pattern is more of a continuation pattern, whereas a double bottom is more of a reversal pattern. However, both patterns have the common characteristic of a bullish reversal.
There are three possible scenarios for a reversal:
- The first scenario is a break-out of the pattern, which signals the end of the reversal and the start of a new trend.
- The second scenario is a continuation of the pattern, which signals the end of the reversal and the start of a new trend.
- The third scenario is a pattern reversal, which signals the end of the reversal and the start of a new trend.
To identify these reversal patterns, traders must have a strong understanding of swing resistance levels. Before entering a trade, traders must determine the resistance level at which a price reversal is most likely to occur. Traders can then use this information to time their entry into trades.
The double top is the exact opposite of the double bottom. A double top is a reversal pattern created by a large, bearish move that ends at resistance. The price then reverses and attempts to close above the high of the prior large bearish move.
Now to backtest the strategy.
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4 Steps to Backtest a Trading Strategy
To backtest your strategy, you should track the following variables:
1. Is the pattern valid for all time frames?
The best forex trading session depends entirely on the stage of the market cycle. Switch between timeframes to get a better understanding of the best forex trading session that suits your chosen strategy - and keep a note of it in your trading log.
There's no "best" forex trading session. But most traders would agree that the London trading session is the busiest. So many traders place their trades during London sessions that forex brokers sometimes give traders "London bias."
The "London morning" session generally begins around 8:00 AM local time in London and ends around 11:00 AM. The New York session is generally the most volatile, with about 20% of global volume. It begins around 7:30 AM in New York and ends around 2:00 PM.
Get clued up on the London trading session>>
2. What were the entry, exit and risk management rules for the strategy?
The most important part of your backtesting results is to understand why the strategy performed as it did. It's very easy to fall into the trap of thinking that you know exactly how the strategy performed, when in fact, you're only aware of part of the picture.
- Entry and exit rules: The entry price, the maximum loss, and the minimum loss are the starting points for your strategy. How much risk are you willing to take? Do you enter and hope for the best, or do you set a profit target and exit when it hits? Knowing these rules will tell you a lot about how a strategy is performed.
- Risk management rules: Once you're in the market, how do you protect your capital? Do you increase the lot size as the risk rises? Do you take profits after reaching a certain level? Do you let losses run? Again, knowing your risk management rules will help you understand why a strategy performed as it did (or didn't).
Setting a stop loss is key to limiting the risk in a trade. See our blog on Where to Set Stop Loss - and Why It's Important>>
3. What currency pair did you use?
When testing a trading strategy, we want to see how accurate and profitable the strategy performed when using different financial instruments or currency pairs. We want to know which financial instruments offer the most accurate and profitable double top/double bottom patterns. Some of the most popular currency pairs include the GBP/USD, EUR/USD, NZD/USD, AUD/USD and USD/JPY pairs.
Here are the 5 best currencies to trade - and here’s why>>
4. When did you spot the pattern?
One of the most critical parts of forex trading strategy backtesting is to determine whether there are days when the strategy has produced better results. If you've found several strong pieces of evidence, your strategy might be ready to apply in live trading.
If you're analyzing forex trading strategies, knowing when to take trades is as important as identifying the potential patterns. For example, if you only analyze the mean average of the results for this double top/bottom pattern, how will you know if it's more volatile on certain days?