AVOID THIS WHEN BACKTESTING IN FOREX

Lewis Mocker knocks out another incredible post!

One of the many challenges of moving away from mechanical strategies into a more advanced/discretionary approach is adopting a false sense of confidence in your strategies based on flawed back-testing procedures.

It’s very easy to say “I would have taken that”…

But, really? Would you have really taken it?

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Over-confidence and naivety can cause us to see more profitable entries during back-testing than what we would have actually traded in real time. As we move away from mechanics, we have no line in the sand to determine what we would have TRULY taken in the moment.

Lack-of-confidence and skepticism can cause us to miss trades in backtesting that we would have (or should have) actually taken in real time!

The lines on this chart, which were drawn with the benefit of hindsight, make it “look” easy to have taken every entry that is numbered 1-6…

But here’s how these lines would have played out in real time:

Point 1. At this point in time, the Orange line doesn’t really exist. It’s just a connection between “current market price” and the most recent swing low. You may have traded this move long based on other criteria, but to assume you’d have traded it based on bouncing from the Orange support line is most likely not rooted in reality.

Point 2. By this time, the Orange line is real. This is because we’ve connected two CONFIRMED swing lows. This certainly does not mean it’s a key line (we want 3+ touches for that). When two swings can be connected, the line is real, and it will cause some traders to set their entry/exit orders on them. If at this point you had a strategy that entered you short at point 2 based on the double top pattern, the Orange line here could be used as a wise target area.

Point 3. By this point in time, the Orange line has been broken, and is currently being retested. IF your strategy is to enter on the re-test of lines based on price action, this is a very valid short entry. Unlike point 2 above however, the PURPLE line doesn’t exist at the time of this entry, and therefore cannot be used as a target.

Point 4. By point 4, the horizontal green line is drawn in as we can easily see we have support in the market. The purple line exists (albeit at a slightly more horizontal angle) based on the most recent swing high. At point 4 we can also see that price appears to be moving into a descending triangle formation.

Point 5. Point 5 is an illusive move for inexperienced back-testers. Many back-testers will say “I would have taken that” short. But would they? In real time, all they’d be seeing is the market unable to break support with bullish MACD divergence. I personally would not have taken point 5 short, even though it turned out to be a profitable run down. By point 5 however, we are able to extend both PURPLE and GREEN lines forward, and anticipate a future break and re-test move.

Point 6. At this point, the market has broken support, and retraced back to retest both GREEN and PURPLE lines as resistance. As anticipated back at the time of point 5, this is a valid short entry should your strategy permit an entry!

The key message of this short post is to ensure you’re acting from a place of mental objectivity when backtesting. Remember to identify and factor in all the losing entries that would have looked fantastic in real-time.

If you’re moving into a more advanced and discretionary approach to technical trading and you appear to be performing worse, don’t hesitate to step it down a notch, back toward a more mechanical approach.

The rule of thumb is, go mechanical until your market awareness and emotional stability justifies a gentle and gradual shift into discretionary trading.

Finally, as you learned in Lesson 9 of the Infinite Prosperity course, backtesting is great for practice but not a reliable indication of future performance. If your backtesting results return 10% over the last month, it doesn’t necessarily mean you’ll make 10% next month.

Keep it real, keep it objective, trade smart!

Have a great week.

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