Backtesting is the process of testing a trading strategy on prior time periods. Instead of applying a strategy for the time period forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data in order to gauge the its effectiveness. When you backtest a theory, the results achieved are highly dependent on the movements of the tested period. Backtesting a theory assumes that what happens in the past will happen 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 markets.
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.
The belief that backtesting can help identify strategies with potential is common, but it is unsubstantiated by evidence or experience. The best way of testing a strategy is by testing its actual performance, which means that we should evaluate the actual gains and losses registered by using it, instead of hypothetical successes and failures in past situations. As long as the sums that are used for this purpose are small and leverage is sensible, the losses that may result are affordable, and even advisable as part of the learning process.