Devising forex trading strategies is a part and parcel of trading in forex. In fact, age old wisdom states that every forex trader should devise his own trading programme on the basis of his unique personality and character.
Unfortunately, no forex trading programme can be really trusted unless it has been properly tested. The established method of testing such programmes is for a forex trader to back test it. Back testing is a process that involves the use of the programme on historic FX trading data and then interpreting the results.
Most forex traders know that back testing, as a process, is dubious at best and extremely misleading at worst. What this means is that regardless of how much you back test your trading system, the inherent limitations of the testing process would make your results suspect.
Knowing the limitations of the process of back testing would, hence, allow you to be aware of how your forex trading system might be limited as well. Consider the following limitations of the back testing process.
One of the reasons why back testing can be flawed is that it does not take into account the fact that forex brokers sometimes increase spread around the time forex news items are released.
They do this because this allows them to make more money from the volatility caused by the drastic change in forex rates in forex trading. While historic forex data may have instances of these changes in spreads, it still cannot take into account the extent to which future spreads can change.
The Limitations of Historical Data
There are only so many variations of time frames that a forex trader can use to back test his forex trading strategies. If the forex trader focuses on short term trading then this could mean that he looks at shorter time spans. However, long term forex rates changes can also affect short term trading.
Similarly, while it is true that market noise is irrelevant for long term forex traders in most cases, if the historical data is only taken for longer time frames then the data can exclude many short term forex rates changes that can affect long term trading positions.
Demo Account Limitations
In the majority of cases, back testing on forex trading programmes are implemented through demo forex accounts. Demo accounts sometimes have variables that are not similar to the real foreign exchange market.
This means that any back testing done on a demo account can yield results that are not the true reflection of what the forex trading programme would do in real market situations.
Uncertain Market Patterns
As mentioned earlier, historical data on forex rates can never account for future forex rate changes. For instance, it is unlikely that the extent to which forex news about the Greek economy can change forex rates are ever housed in historical forex rates data.
Similarly, there could be any number of future instances that can change the way forex rates behave. As the variations that the world can bring about are infinite in nature, historical data on forex trading is inherently flawed.
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