Before you begin trading any currency pair, you need to know that your trading system works under the influence of prevailing market conditions. If your trading methodology includes use of chart indicators, you then need to know that your indicators will also work under current market conditions. This article is about back-testing, what it is and how you can use it to adjust the parameters of your chart indicators in an effort to optimize their effectiveness in providing the clues you need to identify market turning points.
One of the greatest chart indicators that you can use to trade the Forex currency market is also one of the oldest. It is the Stochastic Oscillator as developed by George C. Lane in the 1950′s to help farmers better time the corn futures market. The Stochastic indicator is a momentum indicator and it shows you the value of the closing price of a financial asset relative to the high/low price range over an established number of time periods.
The Stochastic Indicator Showing Gathering Momentum Within An Uptrend
The theory behind stochastics is simply this: In a bull market prices tend to close near the high of the day (or other observed time period), and in true bear markets prices tend to close near the low of the day. If you think about this it makes sense. Markets tend to experience most of their volume surges just after the open and just prior to the close where it is mandatory for some traders to get in or out. If a market is closing soon and there is visible upward momentum building just prior to the close that would be a bullish signal as it is apparent that at least some new money is coming into the market and is comfortable staying through to at least the next session.
Typically the Stochastic Indicator is used as an oscillator for identifying over-bought and over-sold market conditions, it also makes a wonderful indicator to use for trading divergence because it was originally designed to spot changes in momentum. As a rule momentum changes prior to market price, so any indication of gathering or declining momentum on the chart will underscore a price/momentum divergence.
The Stochastic Indicator has three values or settings that you need to input before you can start using it. These values are for the %K period, the %D period, and the SMA (smooth moving average). According to the developer of the indicator the default settings for these 3 values should be: %K=14, %D=3, SMA=3. It should be noted for review that the original use of this indicator was to aid farmers time the corn market and commonly corn is traded off the daily chart. For use with Forex trading which is commonly done on a much shorter time frame, the settings or parameters probably will work better when speed-ed up, so when configuring your Stochastic indicator for Forex currency trading try these settings: %K=8, %D=3, SMA=3.
The true value of backtesting for any trading system comes into play after you have configured your stochastics indicator and before you start testing out your newest trading system (in a demo account of course). Instead of jumping right in with some new trades do this instead:
Scroll backwards on your chart within your favorite time frame and look for market turning points that match up with market trading signals that your system would have triggered if you were trading back then. This is the essence of backtesting — to look at past data and see if your trading system’s entry and exit points actually match up with what really happened. If not, then you have to optimize your trading system and perhaps your indicators as well before you commit money to trading it.
The secret to getting your Stochastic indicator optimized to work perfectly for you in all market conditions is to log into your trading platform and make sure that you have live market data on your chart. This will give you the true measure of how the market is behaving right now. Next scroll back in time (no more than a few hours or so) on your chart and try to match up the obvious high and low turning points in the market you are interested in with the peaks and valleys of the actual stochastic indicator itself. If you do not see a perfect correlation or match up between tops and bottoms in price and peaks and valleys in the stochastics, then you should experiment by changing your SMA setting (make it faster or slower) to see if you can force the indicator to conform. Ideally, you should be able to “tweak” your indicator so that it gives you a signal BEFORE the market price hits its actual high or low turning point.
To begin with we recommend that you set your SMA value to 8 or 9 instead of 14 because as stated above you want a faster signal. If this is not fast enough then try making it a lower number — as low as 5 might work depending on the time frame you are trading off of. If this is too fast, then you will want to slow the SMA down by setting it to 9 or even higher, particularly if you like trading off the daily chart. No matter what your preference, you should always engage in this exercise of backtesting all of your indicators to make sure that they work under real market conditions before you commit real money to trading.
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