Back testing uses historic price moves to determine the future success of a trading strategy.
Back testing is a popular past time of retail traders.
Many look to find an ‘edge’ that they can use to generate profits from the market. Usually, this results in retail traders using technical based strategies.
Through back testing, a trader can test how a technical strategy performs with old price data. Doing so can indicate whether that strategy is likely to be successful going forward.
Do professionals use back testing?
Professional traders do not generally use back testing.
This is because professionals tend to use technical analysis less than retail traders.
However, because of the prominence of technical analysis in Forex, back testing is more popular than ever.
How back testing works
The process begins with constructing a ‘rule based’ strategy. Generally, these rules must be quantifiable.
For example, many technical strategies use an algorithm to identify entry points, stop loss levels and profit targets.
With a ‘rule based’ strategy, a trader can apply it to historical price data. Most popular platforms, such as MetaTrader 4, include options to conduct back testing.
Should the strategy produce a profit with historical data, it could well do the same in the future.
The problem with back testing
Unfortunately, back testing does not reflect the realities of professional trading.
This is because it fails to allow for subjective analysis.
Remember, most professional traders use fundamental analysis. This means they use real-time news and data when making trading decisions.
But the key to successful fundamental analysis lies in the interpretation of how a trader thinks that the market will react next.
This works very much like poker. Instead of playing your own hand successful players will play their opposition.
This is a surprise to most retail traders.
There is a common belief that fundamental analysis is all about interpreting economic data. This is not the case.
To be successful you will need to understand and apply fundamental analysis in this way. This introduces a subjective element into the trading equation.
Obviously, these subjective variables are never the same.
Therefore, it is impossible to accurately back test your own trading, using historic price charts.
The pros of back testing
However, back testing does have some merit.
It can give you an idea whether a specific technical concept is worth exploring further.
But in my view, it will not tell you much about the profitability of a specific trading strategy.
Back testing accuracy
You might have experienced frustration with back testing in the past. It’s common to find a strategy that seems to work well on historic data.
When you apply that same strategy to a live environment, you may find it doesn’t perform nearly as well.
This is because price movements are never the same. The buyers and sellers are never the same. And the moves that result are never the same.
Patterns in price movements fool retail traders into thinking they have an ‘edge’.
It’s never really the case.
The markets are fluid in nature. Each individual price move derives from a myriad of variables and is truly unique. The conditions that cause price to move are likely to never occur again.
Many retail traders point to recurring price patterns to validate predictive strategies.
The ‘flipping a coin’ scenario
Unfortunately, these strategies do not tell us how price will move next. They simply guess based on what’s gone before.
Price patterns are like flipping a coin.
Each time there is a 50/50 chance of heads or tails. But when you get five heads in a row, you start to believe that tails is more likely on your next flip.
This is of course not the case. The odds of tails remains exactly the same as flipping heads.
In the same way, technical analysts see a chart pattern and believe it will continue as planned. Again, this is not the case. The odds of the price moving either way are the same as they were even before the price pattern emerged.
Beware of the switching cycle
Back testing is a serious subject because it can derail your trading progress.
The concept can very often suck you into a cycle of switching strategies. This is why many traders fail.
The switching cycle begins with the discovery of a system or strategy that can be clearly quantified.
The next step is to back test the strategy, until you find great results.
Finally, you begin trading that strategy in a real market environment.
Most traders find that the real results almost never match the back tested ones. They then ditch the system and find a new one to back test. This becomes a continuous cycle.
What is back testing?
Proving how ineffective back testing is very simple.
Take a strategy, back test it and then try and trade it live for longer than three months.
Although back testing is extremely popular in the world of retail trading, it is generally ineffective at predicting the profit potential of technical based systems.