Back testing and demo-ing are a key component for evaluating effective trading system. The theory is any strategy that work well in the past is likely to work well in the future. Conversely, any strategy that performed poorly is most unlikely to perform good results in the future.
Advantages for Performing Demo and Back-testing Evaluation
1. History repeats itself. Repeated patterns can be identified from the back-test.
2. Investors can be educated with key ratios like max draw-down so that they know what to expect when using the systems.
3. Increases investors' confidence to rely on the systems during the draw-down period. Thus, investors know when to stick to the trading rules and when to discard the trading system.
4. Provides an estimate of the probability and magnitude of the potential trade profits and losses because the performance statistics can be reproduced by back-testing.
Limitations of Demo Testing and Back-testing
1. Spreads
Liquidity conditions during certain news hour may narrow the spreads. GMT day spread and night spread may differ due to liquidity conditions. All of this widening and narrowing of spreads may not be accurately accounted for in the bid and ask price.
Strategy that requires certain max spread conditions would not have perform as well in live trading compared to a back-test.
2. GMT OffSet
The server time may change at certain time of the year in UK and US due to summer and winter daylight saving hour. The price and history feeds may not correspond to the specified chart timing. This will mean that certain strategies that only trade at certain hours may get prices mismatch figures.
3. Brokers' Manipulation
Certain brokers' will offer close to ideal trading conditions in the back-test and demo test. This ideal conditions certainly do not happen when trading live. The idea doing this is to attract as many potential traders to use their services. You can find out more information on some of the popular forex forums online.
4. Trade Entry Method
Systems that use market order for entries may face difficulty in getting in at the right price you want in the live conditions. The fact is during live conditions, the market price will be very volatile and getting in at the right price manually will be a problem. There will be a difference in the entry prices between back-test or demo with live conditions.
Summary
Having to recognize the limitations of backtests and demo test, it will help us in understanding more about how the trading systems work and how to evaluate and analyse a system better. It does not mean that backtest results do not work, the fact is, it still works.
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