It is widely known that if you want to become a profitable trader you have to create your own trading strategy which should be tested in order to be proved its profitability. Many beginning traders are using backtesting as a method to prove their strategy’s profitability. Backtesting means taking the rules for a trading strategy and subjecting them to historical data to see if it would have traded profitably in the past.
Backtesting is the process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital. A trader can simulate the trading of a strategy over an appropriate period of time and analyze the results for the levels of profitability and risk. If the results meet the necessary criteria that are acceptable to the trader, the strategy can then be implemented with some degree of confidence that it will result in profits.
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Backtesting in forex works on the assumption that trades and strategies that have performed well in the past will perform well in the future. Although it is done using computers for the most part, you can perform it manually on a sequence of monthly or yearly data. It is an easy and straightforward approach, which makes it very popular in the trader community as an exciting and safe tool in the everlasting quest for the perfect forex strategy. Traders who apply this method for testing their strategies subscribe to the belief that what works in the past will also work in the future.
Backtesting of technical methods in light of past prices is the most popular testing strategy among technical traders. That price patterns repeat themselves is a basic principle of technical analysis. By interpreting this principle to imply that the past performance of a trading strategy can guarantee or at least validate its returns in future markets, backtesting aims to weed out the less profitable tools and filter the most promising ones to be used in trading. But while it is popular, backtesting is made a questionable tool by the chaotic, and constantly changing nature of the forex market.
Not only does the quote change, but even the rules that define the quote also change, ensuring that a method valid today may not be very useful after the passage of a short while. When we are backtesting a strategy, all that we are testing is its effectiveness in conditions that may never be repeated again. Of course, triangles, pennants, breakouts occur all the time, but the precise configuration of each of these patterns is different enough to invalidate the application of past trading choices at each and every single case.