In a previous article, I discussed methods of evaluating a Forex trading system using non-technical methods. In this article, I am going to discuss technical methods of evaluation.
I like to classify the technical methods of evaluating a Forex trading system into 3 basic categories:
1 - Forward Testing,
2 - Back Testing, and
3 - Theoretical Analysis.
Each has its strong points and limitations.
I listed forward testing first because it is usually the easiest form of testing for the average person to do. If you have a system that you wish to evaluate, open up a free demo account with a Forex broker, and begin to trade the demo account using your system. A demo account trades just like a live account, and it is an excellent way to evaluate the performance of a system.
The biggest drawback is that it can take some time before you get enough data for a realistic evaluation. In spite of that limitation, I recommend this method as the most essential, whether or not you perform any other type of evaluation. It would be foolhardy for an individual to begin using a system without paper trading it first.
Back testing is another good method of evaluating a trading system, and it has the advantage of providing results much quicker than forward testing. It usually requires some kind of software to assist in the process, unless you are really handy with a calculator, pencil and paper. One disadvantage is that back testing can never totally duplicate live market conditions, such as liquidity and other factors. Another disadvantage is that previous market movements are no guarantee of how the market will behave in the future. But if you keep these limitations in mind, back testing can be an extremely useful method of evaluating a trading system.
Theoretical analysis is a challenging mental exercise that some would argue is best left for the mathematically inclined. It is often the subject of academic papers submitted by graduate students or faculty. There is usually an abstract that describes the basic premise of the paper, and a person can decide by reading the abstract if they wish to pursue reading the whole paper.
An advantage of theoretical analysis is that it can often open up whole new lines of thought that would be of immense value to someone involved in system development or analysis. In addition, it can be done even when the markets are closed for trading. An obvious disadvantage is that often, only someone with a strong mathematical or technical background can understand it.
An example of theoretical analysis is the random trades test hypothesis by Alex Strashny. It can be found on line at http://ideas.repec.org/p/wpa/wuwpfi/0205003.html .
Obviously, only the most foolhardy of persons would start trading a system live without first performing a test of that system. As you can see, testing a Forex trading system can be as simple or as complicated as you wish to make it.
Even if you do not have a strong technical or mathematical background, at the very least, you can perform a forward test of your proposed system by trading it in a demo account. If you are slightly more technically inquisitive, you could move on to back testing. And finally, the more technically inclined can enjoy an almost limitless fountain of inquiry in the realm of theoretical analysis.
Jerry Brunet is a Forex trader, and software developer. He is the developer of a software program called The Forex-Backtester, which can be found at http://www.forex-backtester.com
Did you find this article helpful? Subscribe to Jerry Brunet's free “Trade While You Sleep" Newsletter at http://www.forex-toolbox.com .