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Guest Commentary: 5 Limitations of Back Testing

Guest Commentary: 5 Limitations of Back Testing

Yohay Elam, Forex Crunch,

There are lots of forex trading system and EAs out there. Some may be good and others can be bad. While it’s definitely a good start, it isn’t bullet proof.

Expert Advisors (EAs) are small pieces of software that automatically open and close forex positions according to the code written inside. MetaTrader has an excellent environment for programming, executing and and analyzing the results of backtesting.

A trader can acquire an EA and test it with specific parameters: stop loss, take profit, different currencies and different periods of time. MetaTrader also enables testing the different options in a single run, saving the trader time.

All this is really great, yet backtesting has its limits:

  1. Spread jumps: when big news come in, the brokers spreads start growing. These bigger spreads are “extra-tax” on the trader. These spreads aren’t always reflected in the historical data provided by the broker.
  2. Future spreads: Following the previous point, you can’t always know when the spreads will jump and how they will affect the markets and your positions. Yes, an event such as the Non-Farm Payrolls release or GDP are known ahead of time. These can be avoided. But breaking news about the Greek crisis can come at any time, move the markets and enlarge the spreads.
  3. One minute resolution: Many brokers supply one minute figures: open, close, high and low values for one minute. They don’t supply every tick in their historic data. Traders that seek long-term moves won’t be excited from this inaccuracy, but day traders miss out on a lot of valuable data and cannot rely on backtesting.
  4. Demo accounts can differ: Backtesting is often done on a forex demo account. The historic data in these accounts isn’t always 100% compatible with the data for real accounts.
  5. Market patterns change: Even if all the historic data is perfect, and your EA shows high profitability for a long period of time, patterns change. Volatility changes for the whole market or for a specific currency. Central bank intervention can surprise and break patterns, etc.

There is no full proof forex robot and no EA that will always work. Backtesting is good for having a general idea about the quality of the EA.Successful EAs should be first promoted to forward testing on a demo account. This takes more time, but provides a higher level of accuracy. Only after successful forward testing, you can try the EA on a real account. But remember – nothing is guaranteed.

Further reading: 5 Most Predictable Currency Pairs - Q1 2012

By Yohay Elam, Forex Crunch

Would you like to see more third-party contributors on DailyFX? For questions and comments, please send them to research@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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