In a previous backtesting post, I revealed the results from a backtest of Trending Outside Bars.
That strategy yielded an average 75% win rate and an average 18% return on seven pairs, over about 16 years.
Yeah, those results won't buy you a Ferrari any time soon.
But I presented the data that way to make a point:
It can be easy to give up on a trading strategy in backtesting when you don't make huge return every year.
That can be a big mistake, as I'll demonstrate in this post.
Reminder: Backtesting has its limitations, but it is a great start for building a trading system.
Most of the successful traders I know attribute their success to backtesting, but there are different ways to learn to trade. Past performance does not guarantee future results.
The Leverage of Compounding Forex Profits
You have probably read a lot about the magic of compounding Forex profits with a bunch of theoretical numbers thrown into a spreadsheet.
That's a great start, but let's look at a real life example from a round of testing that I did.
As I mentioned in the beginning, the results I presented only included seven pairs. Many traders test one pair, then they get discouraged that they only made 18% over 16 years.
So they give up and move on to the next system. Welcome to the Trading Silodrome.
But they miss two important leverage points:
- Compounding
- Trading more pairs/timeframes
Here's how that 18% can turn into 2,381%…
Test Results with Compounding
After I did the test with seven pairs, I expanded the test to all 27 currency pairs that I want to trade live. This can potentially multiply the advantage of the system over several currency pairs. The results were quite good, but still not impressive without compounding.
This is a screenshot from my backtesting journal spreadsheet.
Again, averages can kill your motivation. The average return for all the pairs dropped to 12.81%. On the bright side, the average win rate increased to 77.33%.
If you added the returns, as I did above in the spreadsheet, you would get a sum of 324.32%. That could cause you to give up right now. 324.32% divided by 16 years is 20.27% per year.
Pretty good, but probably not what most traders are looking for.
However, that only shows you part of the potential of the system. You need to take compounding into consideration.
Before we move on, some of you will argue that this next result isn't accurate either because most traders will have to withdraw money for living expenses, taxes, etc. Yes, that is true and you will need to build this into your calculations later. At this point, I simply want to demonstrate the full potential of the system. This can be the key realizing that you have a viable trading system, instead of giving up too soon.
Combine All Results
The key to getting your compounded return is to put all of your trades into one spreadsheet, so you can create your own calculations. Doing this will also show you your maximum number of losing trades, max drawdown, etc. That can be tough to visualize when you are only testing one Forex pair at a time.
In Forex Tester, you can simply export your backtesting results to a CSV file, then import it into your favorite analysis software, like Excel.
Then sort your file by trade open date.
Now you can set variables for your percent risk per trade and your starting balance. Then you can change those settings to see how that would affect your end result.
If you need help setting this up, here's how to do it:
- Calculate the R value for each trade: (stop loss – entry price) / (close price – entry price). I wouldn't worry about the figuring out the decimal points for JPY pairs and buy vs sell. You can use the absolute value of that calculation and use another result field to add a plus or minus. For example, if you have a 3R absolute calculation, you could look at the $ amount profit/loss to determine if it should be a +3R or a -3R.
- Multiply the R calculation above by a percent risk per trade field that you create. So if you are risking 1% per trade and a trade makes 3R, then you would make 3%.
- Then add or subtract the percentage lost/gained on each trade from a running balance column that you create. I usually start with a $10,000 starting balance.
The Compounded Return
Then you will have a total compounded return at the bottom of your spreadsheet. This is the number that you should be interested in.
When I compounded this system, taking 1% risk on each trade, the final result was 2,381.48%. That works out to be 11.97% per month, on average.
Now that's more like it!
When I change the risk per trade to 2%, the total return changes to 53,465.93%.
That is some serious compounding.
Remember, you cannot simply risk more to make more.
You have to find the balance between a good return and being able to handle the drawdowns.
With more reward comes more risk.
Conclusion
This is just the first step in the Trading System Launch process.
Remember that it goes:
Backtesting > Forward Testing > Live Trading
The actual results you get in live trading will probably be a little different from your backtesting.
But it is very important to start with backtesting so you know if your system has positive expectancy or not.
Before you give up on a trading system, remember to factor compounding into your calculations.
It could make all the difference.
