Back-Testing Your Foreign Exchange System

You need to continue to gain expertise, but avoid thinking like an expert.
—Denis Waitley

The consistently profitable foreign exchange trader is an expert. Just as an expert farmer understands seeds and soil, and the expert mechanic can hear the difference between a blown gasket and loose muffler, the expert foreign exchange trader knows markets. Where does this expertise come from? How does the novice foreign exchange trader become an expert? This is the million-dollar question.

Make no mistake about it, when you step into any market, including the forex market, and decide that you want to make money, you have decided you will outwit and outperform some of the most determined, intelligent, and well-resourced people in the world. All these impressive people have one goal: to take your money. How can you make money in the markets, knowing whom you are up against? The answer is simple. Perhaps the answer is much simpler that you would believe.

You must practice.

Practice your craft. Practice your trading. This is the simple way to become an expert. Simple does not mean easy, because many traders expect to become experts without practice, and sadly they never achieve expertise. Consistently profitable trading is yours if you practice trading and become an expert. You now have the secret formula to achieve consistently profitable trading. Will you use this secret? The best estimates suggest as many as 74.8 percent of traders do not use the secret. This is because 74.8 percent of forex traders do not consistently make money trading (Forex Magnates U.S. Forex Brokers Profitability Report for Quarter 2, 2011). The 25.2 percent of consistently profitable traders practice trading to get better at it.

Only 25.2 percent of all of the traders reading this will decide to practice trading to become an expert. It is no coincidence that about 25.2 percent of all traders are consistently profitable. Practice helps achieve expertise in nearly every sport and vocation. It is interesting to see how the vast majority of aspiring traders expect to immediately become successful without putting the effort into becoming an expert.

Expert traders put the effort into becoming an expert. It is ironic that many traders are attracted to the trading lifestyle, thinking that trading will allow passive income to accumulate. This is certainly true, any trader can make money while sleeping, but expert traders are much more likely to achieve consistent, passive income from trading. Trading is like any other job: Practice and effort must be well-placed in order to reap the rewards.

The expert trader may be able to quickly make trading decisions and place trades, but these decisions are the fruits of many hours of practice, in nearly every instance. Traders must earn their pips through practice. Practice means confidence. Practicing your trading system will enable you to keep trading your system, and avoid all distractions and excuses (e.g., terrible-system traders and bad-market traders) along the way. Practicing your trading system will allow you to enjoy the confidence of knowing when you place a trade how likely you are to be successful with that particular trade. Would you enjoy trading more if you had a quiet, unshakable confidence in your trading system? Would you find it easier to walk away fromyour  computer if you knew the precise likelihood that your trade would be a winner? Would it be nice to know that you will avoid the excuses bad-market traders and terrible-system traders make? What would happenif, from  today onward, you maintained confidence in your ability to extract profits from the market even through the ups and downs that are inevitable in any trader’s life?

Consistently profitable traders, otherwise known as expert traders, have one thing in common: They test their trading systems. These traders practice their trading systems. There are many  methods for testing a trading system. Each of them has advantages and disadvantages. Depending on your personality and how you approach your trading, one of these approaches is likely to resonate with you more than the others. Decide which of the three methods you will adopt to become an expert trader.

Each of these methods are back-testing methods. Back-testing is a common term used in trading that simply means “testing a trading system through historical data.” All traders know that using historical data is not the perfect solution to testing a trading system. A much better alternative would be to have future data to test our trading  systems. Failing that, historical data is the next best thing. There are many pitfalls and problems associated with testing trading systems on historical data; however, the consequences associated with trading a system in live market conditions when it is not tested on historical data are much more problematic.

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