Forex involves the active trading of currency pairs on the foreign exchange market. Also called currency trading, forex presents a distinct set of opportunities and risks compared to other financial markets, such as stock or bond markets. In forex, employing a proven and disciplined strategy in the marketplace is essential to maintaining profitability over time. Back-testing allows forex traders to prove strategies and trading systems using real-world data without taking on real risk in the market. Understanding how to back-test a strategy in forex can help you to avoid major losses when trying something new.
Establish Strategy Parameters
Begin by strictly setting forth what your strategy will be. Determine which indicators you will use and which technical factors you will focus on. Determine your trigger points to enter trades based on your chosen indicators and technical factors. Set forth your stop-loss and take-profit parameters, and set goals for trade time frames and per-trade profit levels in pips. In addition to the technical setup, define your risk-management parameters for the strategy, including your maximum loss per day and per trade, the number of losing trades you will allow per day and your maximum position size.
Select Pairs to Test
Back-testing works best when you focus on a single currency pair at a time. Unlike live trading, back-testing allows you full control of the passing of time, allowing you to move through any time frame at your own pace. Even if you wish to test a strategy on multiple pairs, analyze one pair at a time for greater clarity.
Gather Past Data
If you use a fully featured trading platform, you should have access to a back-testing module that will feed historical price data into your chart window for your chosen time frame at your chosen speed. If your platform does not include a strategy tester out of the box, there may be an add-on or plugin to add this functionality. If you choose this route, program the module with all of the information it requires, including the currency pair, total time period, chart timeframe and indicators to display. If you do not wish to go this route, obtain static charts of historical price data to analyze. Set the static charts to display your chosen time frame and indicators before analyzing the data.
As you go through the historical price data, look for buy or sell opportunities that match up with your established strategy parameters. When you find an ideal trigger point for a trade, note that trade on the chart, including your stop-loss and take-profit setup. Using your chosen time-frame target, analyze the market's price action immediately following your hypothetical buy or sell point. Take note of the eventual outcome of the trade -- whether the market hit your take-profit or stop-loss points, whether it happened within your timeframe and whether you hit your profitability target for the trade.
Repeat this process as many times as necessary, using as many individual currency pairs and trades as you wish, to gather sufficient data to convince you of your strategy's strength or weakness. If you find that your strategy does not work out in back-testing, consider tweaking one variable at a time, based on your observations, until you arrive at a profitable strategy.
David Ingram has written for multiple publications since 2009, including "The Houston Chronicle" and online at Business.com. As a small-business owner, Ingram regularly confronts modern issues in management, marketing, finance and business law. He has earned a Bachelor of Arts in management from Walsh University.