If you have visited this blog before, you have probably seen me wax poetic about the benefits of manual Forex Backtesting. But as powerful as Backtesting is for developing legit trading skillz (yes, with a “z”), you also need to understand its limitations.
Backtesting is the first key step in a multi-step process.
Like with all processes, it might take a few iterations and optimizations before you find something that works well from beginning to end.
So I don't want to discourage you from Backtesting by giving you its limitations. I simply want to help you understand how it fits into the overall process of gaining confidence in a trading strategy and learning to become a consistently profitable trader.
To learn the entire process, join TraderEvo.
Alright, now that we have that out of the way, here are the limitations of manual Forex Backtesting.
We Have Different Trading Personalities
You might be a great Biologist, but you could not stand being a Lawyer. On the other hand, your cousin may love being a Lawyer. We are all born with certain innate skills, preferences and personalities.
That's why I get so annoyed when I hear traders tell people that their trading strategy will work for everyone.
It's simply not true.
You and I can trade the exact same rules and we can get totally different results. I might lose money in Backtesting and you may make a ton.
If you cannot replicate the Backtesting results of another trader, then first go back and review the rules. Take a look at their trades, if possible. It can be easy to overlook some key rules or nuances. I've certainly done that before.
However, if you test and review several times, but you still aren't getting similar results, then the answer might be that it isn't a strategy that will work for you.
There's nothing wrong with that.
At least you didn't lose real money and you can now move on to testing the next strategy.
There Might be Hindsight Bias
If you are advancing your candles too quickly in Backtesting, you will overshoot your entry setups. This will give you future information that you would not have if you were trading live.
When you take Backtesting trades based on future information, your results will come out much better than they would ordinarily be.
So when you are testing, make sure that your candle playback speed is at a good level for you. Some people need a little slower playback, others can use a faster playback.
There is no right or wrong answer here.
Only what works best for you.
Live Market Conditions Might be Freaking You Out
Backtesting is a safe environment because you are not risking any real money. But when you move to live trading, there is money on the line and the psychology totally changes.
That's why it's essential to Beta Test or Forward Test before going live with a full-sized account.
The risk that you are taking per trade in Backtesting might make sense intellectually. But you might not be able to handle it emotionally.
Consider this possibility and scale down your risk until you are comfortable following the rules of your trading strategy. Use this calculator to help you figure out how much to risk per trade, to avoid a freakout-level drawdown.
The Spread Might be Different at Your Broker
If a system performs really, really well, be sure to check the spread you're using in your backtesting. You may not be accounting for the spread that could be giving you “free” money that's making your strategy look way better than it actually is.
On top of that, your broker may have a variable spread that could significantly change the results of your strategy in live trading.
So always double check your spread and trading fees. You can do this by opening a demo account at your broker.
You Might Not be Able to Trade at Key Times
Here's an obvious example…
You Backtest a trade that fires off during the London open and it has great results.
But the London open is at 3am for you.
So you miss 85% of the trades because you fall asleep or you don't want to go to bed early and wake up that early.
…and your forward testing results suck accordingly.
The same thing can happen with any trading system.
That's why it's important to understand the times of day when your strategy has the most winners and losers.
You can simply use Excel to graph your wins/losses by time to see when you need to be available to trade. If “primetime” is at a bad time for you, then you should move on to testing another strategy.
Market Conditions May Change
As the saying goes: Past performance does not guarantee future results. There could be fundamental shifts in the markets you trade that render certain trading strategies ineffective.
But here's the great thing about Backtesting a trading strategy first…
If you have Backtesting data, you will know when a trading strategy stops working. Your current live results simply won't match up with your Backtesting results and your previous live trading results.
Without this data, it could be months before you figure out that your strategy has stopped working. By then you might be in a serious hole that you cannot dig yourself out of.
If you are having trouble pulling the trigger on a trade, following your rules or you quit trading strategies after a string of losses, then you aren't confident in your trading strategy. That's all there is to it.
Backtesting is the first step in developing your confidence in a technical trading strategy, but be sure that you understand these limitations before you put all your faith in your results.