What is backtesting?

Backtesting is essentially the testing of a trading system using historical market prices, to see how profitable that system can be. This testing is usually done with computer software that runs the trading system through a period of time in the past.

Why beware of backtesting?

Many new traders think that good backtesting results will guarantee similar results in the future. This is a big mistake because a system that has worked in the past may not necessarily work in the future. And this is because the Forex market is always changing and evolving. The Forex market today can be very different from the Forex market last year. The past does not equal the future… if it did, we’d all be millionaires by now!

What about trading systems with good backtesting results?

Because everyone knows what has happened in the past, it’s easy for anyone to create a trading system that can be very profitable during that time (in the past). But remember: we’re not trading in the past; we’re trading in expectation of the future. Trading systems with good backtesting results may very well fail miserably in the future.

But this fact has not stopped unscrupulous people from selling Forex trading systems based on "excellent" backtesting results. They use impressive hypothetical (i.e. backtested) results as a sales tool. Unfortunately, many traders purchase these trading systems only to have them fail miserably and causing them to lose thousands of dollars.

What can I do to protect myself?

When looking for a good trading system, ask the system developer whether the trading results are actual or hypothetical. Many people assume that hypothetical returns are actual returns, but that’s just not the case.

Now that you know it’s easy to create a trading system based on backtesting (i.e. hypothetical) results, you’ll hopefully be more skeptical about trading systems with little or no actual trading results.

Summary

While backtesting can be a very useful way to test a trading system, it’s definitely not an accurate measure of how the system will perform for you in the future. Be wary of scammers who use hypothetical returns to try and sell you something!