By James Woolley – If you have been involved in forex trading for any length of time, you will know that there are literally thousands of different trading systems being sold online. There are also plenty of systems being given away for free on forums and websites, for instance. So how can you tell if any of these systems are worth using or not?
Well you obviously have to test to see if they are profitable and this involves one thing – back-testing. Back-testing is simply where you use some kind of software to enter the trading conditions and see what kind of profits it generated in the previous months and years.
This can be quite a complex process and one that not many people can do, simply because they are traders not programmers. However it is definitely worth learning how to do this because then you can quickly evaluate whether a particular system is profitable or not in a matter of minutes, or seconds in some cases.
The alternative approach is to do all of this back-testing manually. This is a long time-consuming process, but it is no less valid. It basically involves opening up your charting software, plotting the indicators used by the trading system, and looking at every instance where the system would have entered and exited a trade. You then need to write down the running profit and loss, as well as the number of winning and losing trades.
As regards how far you go back in time, the general rule is the longer the better. The more data you analyze, the better you can assess how profitable a particular trading method is because you can see how it performs in various different market conditions.
One final point I want to make about back-testing is that you shouldn’t just look at the total profit for a given period. You should also look at the maximum drawdown during this time as well because you may find that although a particular strategy generates profits in the long run, there may be times when it suffers say 5-10 losing trades in a row. Therefore if this were to happen again in the future, it could decimate your trading account.
So the point is that the only way to thoroughly test out a trading system is to do some back-testing, whether you do this manually or use some kind of software to help you. This will allow you to see how profitable a system is in various market conditions, and will allow you to see what kind of drawdown you are likely to suffer if you were to start trading it for real. The best trading strategies will obviously generate steady profits with very little drawdown along the way.
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