Earlier this month, we looked at an article from Forex Crunch that covered the first three steps for building a new quantitative Forex strategy. Those first three steps covered brainstorming strategy ideas, defining the rules, and optimizing the parameters.
At that point we had a strategy that we had reason to believe would perform well in a trading situation. The next steps would involve properly testing our strategy in order to prove its value.
Forex Crunch has since published the second three steps for creating a robust Forex system. This post focuses on testing the system that was created with the first three steps. It suggests starting with in-sample testing, then moving to out-of-sample testing, and then suggests some even deeper methods of testing.
The Most Important Point Regarding Testing
While there is plenty of great information in the article about the different types of testing that should be performed on a new Forex strategy, the most significant point that the article makes is actually stated in the introduction:
Relying on the CAR (compound annual return) figure is not always a good idea because this metric does not take into account the risk that was involved in producing those gains.
This point is extremely basic, which makes it easy to overlook. While a strong compound annual return is the end goal of every trader, we all know that there are many ways to arrive at a strong compound annual return, and some of them aren’t worth the effort.
In addition to compound annual return, we also need to be concerned with how the strategy performs from a risk perspective. Looking at statistics like maximum drawdown, profit factor, Sharpe ratio, and winning percentage gives us a better idea of how the strategy arrives at its compound annual return.
This bigger picture view will give us a more qualified overview of what trading the strategy will feel like. We can use that to determine if the amount of risk the strategy exposes our capital to is in our tolerable range.
Testing Forex Strategies
Testing on in-sample data is where we can fine tune our strategies in order to get the return and risk statistics into the desired range. From there, we move to out-of-sample testing where we attempt to replicate those statistics on a fresh data set.
There are also testing methods like Walk-Forward Optimization and Monte Carlo Simulations that can shed even more light onto how our new system can be expected to perform in live trading. The important thing to watch for during this testing phase is consistency. The strategy should perform similarly across all of these different types of testing.
If the strategy produces solid returns through a wide range of testing, it can be expected to produce similar results in live trading.