By Cesar Zambrano at ForexFraud.com
Although back testing has been popular among software developers and some forex traders as a means of testing the efficiency of a strategy in a risk-free environment, its track record as an arbiter of a strategy’s potential is dismal. There’s nothing surprising about that, however, since back testing is a useless tool in most of the roles where it is most frequently utilized. Here are some of the many reasons.
1. Back testing is a marketing tool
Let’s first of all recall what back testing primarily is: it is a marketing tool used by forex software developers to spice up the attractiveness of their offers to unsuspecting and often misguided traders. The difference between the results of back testing and the results of live trading are akin to the difference between theory and experiment. The latter always has precedence over the former, regardless of how convincing the results of a hypothetical back testing run may be.
2. The price action is chaotic and unpredictable
There simply is no way of developing a forex strategy with the tools of technical analysis that will work equally well over the long periods of time covered by back testing. And when traders attempt to achieve the Holy Grail through back testing optimization, the results are often disastrous.
3. The validity of back testing is based on false premises
Back testing is based on the notion that past price patterns are repeated in the future, a contention for which there’s little evidence in trading. It may be true that on a cursory examination many patterns appear to be duplicated on the charts, but when it comes to quantifying that duplication, it rapidly becomes evident that the task is too hard with the tools at hand.
4. Back testing optimization is a disastrous strategy
Back testing optimization is an utterly misguided way of improving performance. It simply ensures that a forex strategy will work perfectly in a past market, the conditions of which are extremely unlikely to be repeated in the future. In this way, a trader or developer almost ensures long-term failure.
5. Mini-trading is the best way to test your ideas
Test your ideas with a mini-account, if you seek to minimize risk. Some brokers allow exceedingly low leverage on mini accounts, and with a very low or non-existent lower limit for the lot size. With the forex market moving so slowly, you can test any strategy you desire with only modest risk of loss.
In short, back testing will only mislead you, and waste your time. Its only value is to the forex software peddler, whose ads will propagate any argument that gives some credence to the system sold, regardless of sensibility, or fundamental value. The best forex broker in the world will not generate one extra penny for your back tested strategy over and beyond what is achieved by a thoroughly run-of-the-mill, random forex method. Discard back testing, and you’ll have more time to devote to more meaningful topics.