Back testing serves multiple purposes that contribute to your success as a trader. First and foremost back testing will allow you to quickly see if the method of trading, the strategy, or the trade setup works more often than not using a large data set without having to wait for each scenario to play out in real time.
Back testing is trade research and data collection. You are collecting data about a set of circumstances and the percentage of the time that they play out. You are also collecting data about the circumstances where the setup does not play out. Most importantly you are training yourself to recognize patterns and setups as they form and training yourself how to execute your strategy.
Do not discount the importance of back testing. The strategy is less important than the traders ability to implement the strategy and back testing allows the trader to rapidly develop the muscle memory and intuition to execute the strategy. When the forex market is closed on the weekends, successful traders are back testing.
Data Collection vs Back Testing
Data Collection involves scrolling back through the charts to see setups and get a rough estimate of how often the setup worked and how often it did not, with all chart data viewable. This is usually one of the first steps in developing a strategy, identify a set of conditions that produce a desired result more often than not. This type of back testing is not meant to train the trader in execution or test a strategy.
Back Testing involves starting at a point in the past and playing the chart forward and attempting to trade a strategy against historical data. This is the traditional back testing that most of us do once we have a strategy that we want to become proficient with. When back testing the strategy we don’t have the benefit of seeing what is to come on the right side of the screen so trade setups form and decisions are made as if they were occurring in real time, with the advantage of being able to pause the chart and make a decision. This is training yourself for the live market by becoming proficient with pattern recognition, setup identification, and trade execution. For back testing to be successful, you still must collect the data from the back testing session. If you don’t track it and quantify it, you will not be able to improve it or develop confidence in it.
Documentation
Back testing and data collection both require a means of collecting the data gained from testing. This may be the part that slows down the process as data needs to be collected manually if the back testing platform used doesn’t do this automatically. An excel spreadsheet can be used or even a physical notebook. There are back testing software that will accumulate statistics for the trader, but the data collected may not be specific to the data that you need.
Some useful data to be collected while back testing:
- Date
- Day of the week
- Time of the day the trade was entered
- Time frame traded
- The currency pair
- Buying or selling
- Entry signal used (engulfing, pin bar, morning/evening star, etc.)
- Entry price
- Fibonacci level used for entry
- Fibonacci level that price ultimately reacted from
- % that each Fibonacci level worked
- Condition of any indicators at the time of entry
- Stop loss price and pips
- % Stop loss was hit
- Take profit levels and pips targeted
- Take profit levels actually achieved
- Hit % of each take profit
- Manually closed trades
- Screenshot of the trade before or at time of entry
- Screenshot of the trade after the trade is over
- Notes about the trade
Corrupting Your Data
To be useful, back testing must be unbiased. You are not back testing to inflate your ego about your skills or your strategy. You are attempting to get unbiased data about whether it works or it doesn’t work for you and under what conditions. Don’t try to rewrite history by saying, “I would have done this and that trade would be a win”. If you add a condition to the strategy such as “I would exit if 2 consecutive doji print while I’m in profit”, make it a rule and test the results with that rule in place. This is a mechanical process not a discretionary process. In order to develop confidence in your strategy, you have to know for a fact, based on data alone, that the strategy has an edge when a certain set of conditions are in place.
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