For trading Forex online you will need a profitable and reliable trading strategy.
After developing a strategy one crucial thing to do before starting real trading is to test your trading strategy and skills with backtesting. Backtesting enables you to understand whether your trading strategy has a chance of success.
For backtesting, trading simulation software is very useful. Trading simulation software takes historical data and simulates the historical environment as if it was real-time trading.
Before the simulation traders were testing their strategy on a demo account without real-time movements. With various tools available online backtesting has never been this easy. Down below, we will give you a detailed explanation of FX backtesting and everything that is needed for a better Forex experience.
Important Forex Backtesting Terms And Ratios To Know Before Starting The Backtest
First, you need to know more about the FX simulation software and how it works. Learn more about forex simulation here, so that you are equipped with proper knowledge. Then you need to grasp the terms risk-to-reward ratio, drawdown, and hit rate. These three are essential in evaluating a trading strategy.
The risk-to-reward ratio refers to how much you risk to get 1 unit of profit. If your stop loss is 20 pips and your take profit is 40 pips then the R:R ratio would be: take profit divided by stop loss. In our case: 40/20=2. This means your R:R is 1:2. You risk 1 to get 2. Drawdown is also very important and it shows how risky your strategy is. Anything above 5% is considered relatively risky. 3-5% is a comfortable range for profitable trading strategies.
Hit rate defines the success rate of strategy. If from 100 trades 60 were profitable then your hit rate will be 60%. Using a hit rate to define risk to reward ratio is a great approach. If R:R is 1:2 and a hit rate of 60% congratulations you have got a profitable strategy, just make sure the drawdown is at comfortable levels.
Trading Strategy Backtesting In Three Steps
The goal of backtesting is to see if the trading strategy was profitable if it were traded on historical markets. It is a good indicator to see if the strategy could be used in real markets.
Depending on if you wanna trade automatically with a Forex expert advisor or manually the steps could be different. MetaTrader enables FX EA backtesting in seconds. While with manual trading you can simulate trading with historical data. The three steps for backtesting are:
Step one – Select The Strategy Type You Are Comfortable With
Some traders love scalping the market for many small profits. Others prefer to open a trade and leave it for hours or even for days. It all depends on the trader’s personality. So, during the strategy type selection, make decisions according to your trading goals, experience, time resource, and investment amount. This will give you a more clear picture.
Step Two – Run The Backtest And See How Well Your Strategy Behaves In A Simulated Market
Although past performance is no guarantee for future success, testing and making sure that strategy has performed profitably in a historical environment is crucial. Depending on the time period, results could be different. You could test your strategy on the past 10 years of data or maybe 1 year if it is a short-term strategy.
Step Three – Tweaking The Strategy
Start by changing the parameters and settings you think to affect the strategy negatively. Maybe your stop loss is too large or bigger than your take profit resulting in a few losing trades and canceling all the profits. Reduce the stop loss and see how well the strategy behaves with the new risk-to-reward ratio.
Generally, the 1:2 risk-to-reward ratio is very popular among experienced traders. But for scalpers who are making many trades in short time periods, 1:1.5 or sometimes even 1:1 may be a better solution. If a strategy has a hit rate above 80%, a Risk to Reward 1:1 ratio would be more than enough to make profits.
Demo VS Simulation Main Differences
Although the two are very similar there are substantial differences. Simulation is using historical data while demo trading is real-like trading except the funds are virtual and not real.
Demo enables traders to trade real markets in real-time with virtual money while simulation plays historical data as if it was real-time. There are pros and cons to both methods. Simulation enables time removal and can accelerate candle formation speed while on demo everything is happening in real markets.
So, simulation enables traders to backtest their strategies much faster than on demo trains, but is on a historical basis and doesn’t provide higher future proof like demo trading. But during a demo trading if the strategy is not a scalping strategy it may require traders to watch the screen for hours to catch preferred setups on the chart.