Most traders already know that designing an algorithm to trade in the forex market is an essential step. We also know that any such algorithm is generally based on several indicators, with ATR, the confirmation indicator, and the exit indicator altogether partly making the algorithm’s skeleton we will disclose fully as we progress. What some traders are curious about, however, is the way to backtest these indicators in order for them to assess their performance. If you come across an interesting indicator that you want to give a chance and see whether it works, it is only natural that you would want to apply it in your charts and see if it rendered any success in the past. If you have already had the opportunity to do some research on the indicators that forex traders use, you probably know which ones are the most popular. However, do not give in to the popularity of some outdated tools, such as Stochastics, Japanese Candlesticks, or RSI, because you may certainly have more luck with some of the more modern indicators designed specifically to trade in the forex market.
While some sources insist that there is no such thing as a bad indicator, you may need to ask yourself what your ultimate goal is because one indicator cannot possibly serve all trading needs. On top of that, the market of trading currencies, which have no intrinsic value themselves, cannot possibly be the same as the trading stocks, commodities, or other equities that, unlike fiat currencies, actually have real values. Therefore, even the way we perceive trading can affect our choice of indicators. Nonetheless, even if you are certain that an indicator would perform well, there is no one single reason why you should not test it and compare it, if possible, to some other tools you have used for the same purpose.
What is more, as it turns out, you may find out that some indicators, such as Heiken Ashi, are generally used for entering trades, while some professional traders warn people about its shortcomings and suggest that they use it as an exit indicator and as a tool to test other exit indicators instead. Furthermore, the previously mentioned indicator is a perfect example of tools that do not let traders adjust any settings, which may be a much-needed option for many trades. Another almost equally important topic besides indicators is planning due to the fact that the right strategy and an overall plan on how to enter and exit a trade, including your risk and win limits, will inevitably have an impact on the quality of your trading. In addition, knowing how to scale out is another precondition for trading successfully, which will determine the level of safety and possibly stabilize the situation should your finances ever be at risk because of some unforeseen events.
Professional traders around the globe know that indicators alone cannot be fully functional and bring us all the profit we desire unless we put effort into learning. Therefore, in the process of looking for a good indicator, you must first be aware of the nature of the market you trade, understand its needs, and see what your own needs are. Testing at this point can be not only better because you have a vast array of information at your disposal, but it can also lead to some truly amazing discoveries such as where you can use and how you should never use a specific indicator. Consequently, testing, along with demo trading, should be a precondition to using any tool in real trading, which is why we intend to discuss the tools which can help you backtest and enter any trade with peace of mind. In today’s example, we will go through the steps of how you can backtest a confirmation indicator, which should serve as an overall useful guide and the path to discovering backtesting indicators in general.
How should we then commence this process? Firstly, after finding a confirmation indicator which you are willing to test for yourself, you should choose a specific currency pair for testing the indicator of choice, open your daily chart, and turn this indicator on in the chart. You will be using the default settings at first and, interestingly enough, these default settings often prove to be the best choice after all. By using the default settings, you also give yourself more room to compare later on with some other values after some adjustments. This is the best way to begin this process and what you will also do here is put the ATR indicator in the MT4 platform right below the confirmation indicator in question.
At this point, you will probably need to go at least 6—12 months back in time, although you can always decide to go even further in the past to get even more signals. Some professional traders choose to go back as far as two to three years because a longer time span provides them with a bigger sample size and a clearer idea of how this tool can work out long term. Going too far back, however, is not something experts would recommend just because of the vast number of market changes that have such a profound impact on trading and also because the odds of some market conditions occurring once again are quite low.
Your next question will likely be related to the number of entry signals your confirmation indicator can give you because you really need to find out what a win and what a loss was before. ATR will come in handy here since you will compare it with the number of pips you could have made with your indicator of choice. If the ATR for the USD/JPY currency pair was 80 at the time of entry, you will want to discover if your new indicator made 80 pips before losing 120 pips, because the system we are using sets out first take profit level at 1xATR value (you may want to experiment with different values but this value proves to be the best on the daily time frame according to our tests).
Naturally, if the answer is yes, then it is a winning choice and vice versa. It is of utmost importance to record this information in a clear way so that you can always go back to it and use it for future analyses (e.g. spreadsheet as suggested in the table below). As you will go backward, you will want to document every time you get the same results like these, so for your specific time frame, you can obtain very comprehensive win-loss ratio information, which can help you get a winning percentage on which you can base your decision whether you will use that particular indicator or not. Generally speaking, there are a few other questions you will need to answer before you start: what is the number of currency pairs you will be testing with this indicator, will you be changing the settings, how many times will you tweak the settings, and how far back in time will you be going?
The only rule you should be following is to maintain separate sheets or tabs for different currency pairs. The table below should successfully exemplify how you can keep the necessary data and, to calculate the percentage of wins, you can either divide the wins by the total number of trades yourself or set up a function to do it for you. For example, if the Win % is located in the E column, you may create and duplicate the following equation for all indicators you wish to test: C1/(C1+D1)=E1. The reason why we store this information so meticulously lies in the fact that you will need to go through the same process again for other indicators at least and use the data you collected to rank all of the tested indicators based on how well they did. The two to three indicators with the highest win percentage are actually the ones on which you will be focusing from that point. Although we lack the information regarding what happened with the trade afterward and we do not have any news events involved as well as other relevant data we would otherwise be using in a real-life situation, it will suffice for the time being.
Even though backtesting in this simple manner may seem devoid of some important circumstantial data, it can still help you distinguish between winning indicators and the losing ones as well as pinpoint some vitally important information you will definitely need for your day-to-day trading in this market. Simply put, if you are already witnessing the scenario where any indicator is showing poor performance at this point, imagine how poorly it will perform once you have all facts at your disposal and decide to actually invest real money.
On the other hand, if you come across an indicator which offers a greater number of wins as opposed to losses, you can assume that it may be possible to include this tool in your algorithm in the future. What you will do here is wait on it, but you will also need to and want to know which ones are worthy of hanging on to. Once you have figured this part out, you can freely use it in trading, of course initially in your demo account. Testing out whether an indicator is legitimately good will not require an unreasonable amount of time, especially if you take recording data seriously. In the greatest number of cases, the few winning indicators that you select will outperform the losing wins by far. Now, depending on the type of indicator you are looking for, you may need to consider some other pieces of information.
For example, if you are looking for a confirmation indicator, you know that it should be able to signal favorable market conditions as well as tell you when the market is not ready for any action. Unfortunately, we could not have the same process for testing exit indicators since we would need to include trailing stops that are used to compare with your exit indicator of choice. Nonetheless, no matter how crude backtesting may seem to be, the data you gather should be relevant enough for you to know what your next step should be. To sum up, you will start from today firstly go back to a specific time in the past until the moment you see your indicator telling you to buy or sell.
Secondly, you will check for the ATR at that exact point in time when you discovered the buy/sell signal. And, thirdly, attempt to discover what happened first – the price hitting the ATR value (take profit) or the value of 1.5xATR in the opposite direction (stop loss level we use in our algorithm example). Keep repeating the same process for every indicator and every setting each time the indicator gives you any signal until the time you decide to stop recording data. If you have found a really good indicator, you can use it until a better tool comes along. Whatever you do, keep searching because this market, as well as the tools used for the purpose of trading currencies, is unbelievably prone to change and you may want to be equipped with the best and most modern tools you can get.
Maintain the level of curiosity which is necessary for this line of business and keep your records neat and tidy because you will inevitably direct your finances according to what you discover while backtesting. Finally, although this backtesting method is imperfect at this moment, its power lies in its ability to tell you which the winning and the losing indicators are, saving your time and quite possibly your finances. Together with your comprehensive knowledge of the different types of indicators, the forex market, and your personal goals, this approach to backtesting will surely lead to success and these are the skills you will always be able to use to your advantage regardless of the outside factors.