What is forward-testing in forex, and why is it a must-do? Traders cannot quantify their trading strategy to great lengths, resulting in a lack of confidence and understanding of their performance. While forward-testing is a difficult concept to put in practice, along with other considerations, this article aims to provide the necessary actionable tips.
One of the reasons why traders have little or no confidence in their abilities is they haven’t thoroughly tested their strategies. Anyone can find a so-called profitable system online, but putting it through its paces to see if it will yield consistent long-term results is the tricky part. Forward-testing aims to solve many of these challenges.
This article will define what forward-testing is, why it’s better than back-testing, how long traders should back-test, and some of the guidelines to performing this action as best as possible.
What is forward testing (and why is it far better than back-testing)?
Forward testing refers to testing or trading a specific forex strategy in a live setting, typically using a demo account (also known as paper trading as it does not involve real money). Better results can manifest on a real account if one trades with nano sizes, as the demo doesn’t always accurately depict actual market conditions.
Nonetheless, unlike back-testing, forward testing simulates a trading strategy using present rather than historical data. Although back-testing has its advantages and is less time-consuming, it does not accurately consider all the conditions that may occur on a live trade, such as the possibility of spread widening, slippage, etc.
Executing a trading strategy isn’t only about statistical analysis, but the psychological aspect holds weight, something which one cannot feel when back-testing. Forward testing makes it hard to say, “I wouldn’t have taken that trade” because by defining specific parameters for every trade entry in a real-time setting, you properly account for losses and any weaknesses that’d show up in the future.
How long should you do forward testing in forex?
Unfortunately, it is impossible to unanimously state a time a trader should do forward testing as it’s dependent on numerous factors, like the trading strategy itself, the style of trading, the software used, the unique behavior of different markets, etc.
However, we could conclude a consensus that proper forward testing should occur over at least a year regardless of the trade frequency to ensure the highest accumulation of data.
For example, someone could forward-test a day trading strategy within a month and be able to gather ample data due to the frequentness of such trading styles. The question then is would this be enough time to definitively conclude that the strategy can stand the test of time? Market cycles and conditions have a massive influence on the time traders should perform forward testing.
Market cycles and conditions
It is generally difficult to know the actual state of the market conditions until after the fact. For example, trend-following strategies perform well in trending conditions but fare miserably in ranging and reversal markets.
We will never conclusively tell when a market enters sideways or reversal market territory until after some time. So, while someone can gather sufficient information about the viability of a trading strategy in a month, this data would certainly change in a different market cycle, drastically affecting all the elements of a system.
Therefore, to experience all the kinds of cycles and conditions, forward-testing over at least a year (ideally from the very start of January until December) is wiser. One can make several adjustments along the way to gather more accurate data.
The issue of sample size, once more, links to time. Too many traders place irrelevance over importance on one isolated position. Any system produces a random distribution of losers and winners. The only way to truly see how a trader’s edge plays out over time is by forward-testing a large sample size of trades, which, again, takes a very long time.
Guidelines to proper forward-testing
Below are the critical steps to efficiently implementing forward-testing in forex.
Defining strategy elements
Back-testing is the first phase determining the viability of a rule-based trading strategy. Though there is still a relevance to back-testing, traders ideally should not observe data older than a year for any system they’ve found.
The elements of a trading strategy are plentiful and require dedication, but generally, they should include the traded pairs, the rules of entering a predefined pattern derived from price action or indicators, the amount of risk per trade in relation to the total equity, risk-to-reward, trade management and so on.
Every rule must be well-documented and respected in the back-testing without deviation as this forms the backbone of the forward-testing.
Choosing your testing playground
Assuming they have found a profitable strategy, now it’s time to decide whether to forward-test on a demo or live account. As stated previously, demo accounts cannot, in any way, completely simulate the psychological aspects of trading, and there are some nuances here that aren’t reflective of real life.
At the same time, there is no risk of actual money. A live account is a real market, though there is the danger of real funds. Nonetheless, it is still a much better arena for forward-testing. The only low-risk alternative is for traders to open a nano account with small disposable funds they are comfortable with losing.
One is also likely to be more engaged in this time-consuming process and take it more seriously.
After deciding whether to trade a demo or real account, arguably, the most crucial aspect of forward-testing is deciding the journaling mechanism for tracking the performance.
While there are numerous methods of journaling, many of which are manual, fortunately, there are platforms like Edgewonk that automatically perform this action by connecting directly to one’s account.
Not only can Edgewonk journal and provide valuable analytics, but another crucial attribute is the ability to simulate a trader’s results 500 trades in the future. Traders can find a similar feature on many other trade simulators. The purpose of such a product is to give an overview of how a strategy would fare in the future, cementing the whole purpose of forward-testing.
Forward-testing is a concept many traders don’t devote as much time to as it deserves. However, when performed thoroughly, it can provide much-needed confidence for anyone in the financial markets and strengthen the framework at which they approach it. To summarize, below are the main points of efficient forward-testing in forex.
- Study a profitable trading strategy and back-test on a demo account on data not older than a year. This system should have clearly-defined parameters (traded pairs, pattern and/or indicator used, the rules to enter these, risk-to-reward, trade management, etc.).
- After this stage, the next step is deciding whether to forward-test on a demo or real account. While the former is risk-free, it lacks the psychological depth provided by the latter. A trader should only consider going live if they open a nano account with small, disposable money.
- During the forward-testing, accurate and updated journaling, preferably done digitally and with a simulator, is the most important step for tracking the performance of your strategy.