Discover this Forex Broker Nightmare. Read this shocking 40 page FRWC Brutal Truth FREE Report that reveals a lot about automated trading systems. Learn this powerful Fibonacci Retracement method FREE that pulls 500+ pips per trade. Your trading system needs thorough testing before you decide to trade live with it. A trading system might comprise of a set of indicators. You need to know how well your trading system and its set of indicators work in a particular market.
For this you can do back testing. Back testing is a method that uses historical data to test how well your indicators work in a particular market. You can use back testing software that enables you to look at the past market data and test how well the indicators and your trading system have worked in the past market.
Now, back testing is done with historical data. What this means is that although your trading system might perform very well with back testing, it may not work in the present market. Market conditions keep on changing and what worked in the past may not work in the present. In the same way, what didn’t work in the past may start working now.
In other words, no two trades work out in exact the same way twice. SO you have to be careful when looking at the back testing results and take it with a pinch of salt. However, there are still some advantages of back testing a trading system.
Back testing can give you a feel how a particular market behaves under certain conditions. Back testing can also spot you certain general characteristics of the market like the seasonal trends and market tendencies.
Some markets are highly seasonal. For example, if you are a commodity trader and tend to trade agricultural commodities like the grain, seed or the livestock, these have a fixed planting and harvesting cycles.
On the other hand, you might not find much seasonal trends in the currencies and bond market. Some though talk of the January Effect but this effect is not that pronounced now a days. In case of stocks, stock prices tend to rise at the end of each month and the first few days of each new month as institutional investors tend to put new money to work during that time frame.
Back testing can also help you establish the amount of time a particular market tends to run in a certain direction. For example, in case of US Dollar Index, its trend lines tend to last for months to years.
Now when you back test your trading system and the set of indicators, you can check their accuracy. For example, if you using a trading system based on moving average crossovers, you can back test it using different combinations. Then monitor each combination under live conditions to see which works the best.