What is Backtesting? The Best Forex Backtest Software Today

Backtesting (or Backtest) is considered one of the most important aspects when developing a trading system. Without this method, investors wouldn’t even think about risking their money in the financial markets.

Let’s relate it to reality. When you want to buy anything, especially valuable assets like cars, motorcycles, or phones, you would want to check the brand history, features, standout qualities, etc. You do this because you want to know if the money you’re spending is worth it. The same principle applies to trading, and backtesting is the method that helps you do that.

So, what is Backtesting? How does the backtest work in Forex trading? What factors affect the backtesting trading results? Let’s dive deep into these topics with Finance Solutes in today’s article.

Let’s get started!

1. WHAT IS BACKTESTING?

In this section, Finance Solutes will clarify the concept of backtesting and explain how the Forex backtesting method works.

1.1. What is Forex backtesting?

Backtesting is the process of evaluating how a trading strategy or analytical method could perform based on historical data. It is considered one of the key factors in developing an effective trading strategy.

There are many possibilities for a trading strategy, and even the smallest change can alter its results. This highlights the importance of backtesting, as it shows whether certain parameters perform better than others.

To perform the Backtesting process, you need to have a trading strategy. At the very minimum, you must define entry and exit points for both winning and losing trades, along with your position size. In addition, a trading strategy typically provides context—such as when trades should be executed.

More specifically, Forex Backtesting is the act of planning trades based on historical data. Investors use past data and charts to develop future investment plans.

1.2. How Backtest Trading Works

Investors use Backtesting as a way to test and compare different trading techniques without incurring any actual costs. The theory is that if your trading strategy did not perform well in the past, it’s unlikely to perform well in the future (and vice versa).

The two main factors considered in this method are overall profitability and the level of risk taken. Depending on the Backtesting software used in Forex trading, analysts can receive a wide range of metrics, such as:

• Return on Equity (ROE): Profit expressed as a percentage of total capital invested.
• Total Profit and Loss (P/L): The overall gains and losses generated by a strategy, expressed as a percentage of invested equity.
• Annual ROE: The total return that a Forex trading strategy could generate over a full calendar year.
• Volatility: Market conditions in which your strategy operates—whether in an uptrend or downtrend.
• Risk-Adjusted Return: Calculates profit in relation to the risks of the strategy.

All these metrics provide detailed insight into how your Forex trading strategies are performing.

2. PURPOSE OF BACKTESTING STRATEGIES

So what is the purpose of applying the Backtesting Strategies method?

2.1. Understanding Trading Strategies Across Different Markets

To build confidence in a consistent trading strategy, investors can test it under various market conditions.

This means running tests during clearly trending periods and comparing them to periods of low volatility or sideways movement.

2.2. Upgrading Your Trading Strategy

This involves making adjustments to a strategy after reviewing the results from a backtest.

However, a common mistake here is that traders continuously tweak the strategy to achieve better results with each backtest. Unfortunately, this approach rarely leads to actual profits when trading with real money and is considered overfitting.

2.3. Helping Traders Build Confidence

This method is an effective way to build confidence, as traders gain experience by testing strategies against historical price data. It helps investors feel more secure when they begin live trading.

3. FACTORS AFFECTING BACKTESTING TRADING RESULTS

Several factors can affect the results of the backtesting process, such as:

• The quality and source of historical data
• Clearly defined backtesting strategies

3.1. Quality and Source of Historical Data

The accuracy and reliability of past price data are crucial in conducting backtesting. It must also be relevant to your trading strategy. Note that not all data is created equal in the OTC market. Banks and online Forex brokers may have different data for the same time period.

3.2. The Trading Backtesting Strategy Should Be Clearly Defined

Have you ever wondered how results might change when the same strategy is applied multiple times to the same dataset?

A backtesting strategy should be 100% defined. You should get the same results every time you test your Forex strategy on a specified dataset. While this may be an ideal scenario, it doesn’t always happen.

4. BEST FREE FOREX BACKTESTING SOFTWARE IN 2022

There are many free Forex backtesting software options available to traders. However, the two most popular and widely used platforms among analysts are MT4 and TradingView. Let’s explore how to backtest trading strategies on these two platforms with TradaFX.

4.1. MT4 Backtesting Guide

To perform MT4 Backtesting, investors need an EA (Expert Advisor). You can either learn how to code them or purchase from reputable providers. Here are a few simple steps to successfully perform an MT4 Backtest.

Step 1:
Open the MT4 platform. On the toolbar, select View, then click on Strategy Tester.

Then the MT4 interface will appear like this:

Step 2: You should choose an EA in the Expert Advisor section that you want to install.

Step 3:

In the View section, select Symbols to choose the currency pair you want to backtest, along with the timeframe in the Period field. Next, simply check Use date to select the time range you want to conduct the backtesting for.

Step 4: Select the Model value

In the Model section, choose the corresponding values as follows:

• When an investor selects Every Tick, it provides the most accurate results but takes more time.
• Choosing Open Prices Only will yield faster results, but with lower accuracy.
• Selecting Control Points means the test runs only on the timeframe and will not be as accurate as Every Tick.

Finally, simply click Start to begin the backtesting process. If you want to view detailed statistics, you can select Result, and it will display your backtest results in the Graph section.

4.2. TradingView Backtesting Guide

To use the Backtesting tool on TradingView, if you’re using the Basic plan, you can only run it on the daily (D) timeframe.

If you want to use lower timeframes, you’ll need to upgrade to the Pro plan or higher.

To start backtesting, follow the steps as shown in the image below.

After that, select Bar Replay and click on a point in the past on the chart to begin the backtest.

Simple, right?

5. NOTES WHEN PRACTICING TRADING BACKTESTING

Traders should perform backtesting over a long time frame, including various market phases. The more data used, the more accurate the backtest results will be.

A trading strategy that yields good results on the Forex market does not necessarily mean it will be effective in the stock market.

Markets are constantly changing. Therefore, a strategy with good backtest results does not guarantee future success. Every trading strategy should be accompanied by a sound risk management analysis method.

6. SUMMARY

Backtesting has proven to be one of the biggest advantages of algorithmic trading, as it allows investors to test their trading strategies before actually applying them in real market conditions.

Through today’s article from Finance Solutes, you’ve learned what backtesting is and how to perform it on the two most popular platforms in the Forex market: MT4 and TradingView. We hope the information we’ve shared will support you on your trading and investing journey.

Wishing you success in your trading career!