The way to achieve true diversification is to include currency investments and active trading strategies into one’s portfolio. Currency investment takes many forms, from the very conservative buy-and-hold of government bonds nominated in foreign currencies to short-term speculation on forex. Currencies rise and fall out of sync with stock markets. For example, while the Dow has lost 34% in 2008 (Jan 01 to Dec 31), the Japanese Yen gained 23% in the same time period. Of course, the opposite may happen as well. It is important to note that currency exchange rates are affected by different factors than stocks. A stock has a natural tendency to follow the company’s earnings. If the company grows its business, the stock price follows. Currency value does not depend on the health of a country’s economy as much as on the actions of the issuing central bank and inflation. Consequently, the main difference between stocks and currencies is that stocks in general can be expected to grow long-term, while currencies change fast in respect to each other, following the general direction to lower purchasing power because of global inflation.

Because of this, holding currencies for extended periods of time is more risky than implementing a short term active forex trading strategy. Gains and losses realized in currency trading do not necessarily depend on the direction of the market, but are determined by the strategy itself. For example, a strategy built to trade short in bear market rallies can perform exceptionally well in the current environment with the dollar — but more importantly, it will add a negatively correlated component to the portfolio. Brokers provide a number of ways to implement an active trading strategy, including highly automated online forex trading terminals that have the ability to automatically analyze the market and place orders.

While investing in currencies is necessary for asset diversification and provides many benefits, including protection from loss of the purchasing power of the dollar, it is also not something that should be undertaken lightly. Investing in currencies is not similar to the more conventional forms of investment, and requires a skill set that most retail investors don’t have. This is precisely the reason why investment in currency is not recommended to clients by mainstream financial advisors – they consider it best to be safe than sorry and, frankly, this advice is the best one for many people whose itch to get rich fast overcomes their ability to reason.

However, when used as a diversification and hedging tool rather than a high risk speculative instrument, forex trading has a legitimate place in a portfolio. It is easy to get a first hand impression — any broker will be happy to offer a free forex demo for practice, without any obligations.

The demo is only a simulation. The difference is about the same as between flying a Boeing 747 in a flight simulator and actually landing the thing. By analogy, most people that spend a lot of time playing with fake money, winning contests, and getting high virtual profits with excessively risky trades, often show less than spectacular results when they attempt to do online forex trading in a real account. 

The reason why demo is so different from the real thing is two-fold.

The first and most obvious difference is in trader psychology. A great change in behavior happens when the person is aware of risks and rewards associated with a certain action. Would you agree to make a two-week business trip to Paris? How about Baghdad? What if you get triple pay while in Baghdad and can stay at an army base? What if you get triple pay, but need to travel the country alone? The answer is different depending on the circumstances, although the action that you need to perform remains the same. Fear and greed rule the markets, and no matter what you tell yourself, you will act differently while trading with your own real money on forex. It’s a fact of life and there isn’t much you can do about it, except constantly being aware of this effect and learning to adjust to it.

The other and less well known difference between demo and real trade is in order execution. 

Demo forex accounts are always handled by a computer. A human dealer is most likely involved in execution of your trades in a real account if your trade is bigger than the minimum, market volatility is high, or your account is flagged for some type of undesirable activity. As a result, your trade can take several minutes to execute, while it is practically instant in a demo account. Unfortunately, the faster the market is moving, the longer is the delay. Especially if you use market orders, the price at which you finally get filled can be very bad.

If that weren’t enough, forex simulation on a demo account does not model the filling process. The demo simply takes the price feed, usually from Reuters, and “executes” your order on the basis of the last available price. When you are trading forex live, especially during high volatility, you will probably experience problems with filling. The dealer may inform you that there is no current price, or when you finally get a quote, it may be way off from what you see in the feed.  Stop orders don’t work quite as well, too.

Altogether, demo forex is too forgiving. Your judgement is way better than normal because of the lack of stress. You don’t second-guess your decisions in the demo, and it’s a lot easier to cut virtual losses than to cut the real ones. Order delays and bad fills don’t happen. Stops don’t slip.  Because of this, many of the skills that you learn in the demo work to your disadvantage. Of course a strategy that loses in the demo is guaranteed to fail in the real market as well, so this type of testing helps, but it doesn’t work the other way around. Success of a strategy in the demo may or may not be indicative of its real performance. This is why the best course of action is to spend just enough time in the demo to learn the software and market basics, and move on to the world of real trading as soon as possible. 

If you don’t have a demo – open one now.  Poke forex with a stick and see what happens.  Again, any of the brokers presented here will be happy to accomodate you and answer all your questions.  Don’t dwell on it, the time to pick the broker that is right for you will come later.  Use your demo to learn the functions of the terminal, learn to make trades without silly mistakes such as buying when you wanted to sell, and, most importantly, learn how to use stops.  Get a feeling for it. Once you know what you should expect to see in your account when the market moves, decide whether  you want to pursue currency trading and accept the associated risks.  If you do, read up a bit, it will make a lot more sense with demo trading experience, I assure you, and start to learn the right skills with small, but real money.

Everyone who is making a living on forex now, started with a demo account and learned through practice.  Think about it and act today.  Find a broker that appears most friendly on this site and open a demo.  It is free and there are no obligations – what have you got to lose? 

Happy Trading!

Now, what is backtesting? As the omniscient Wikipedia puts it, “Backtesting is a process, usually performed with aid of computers, by which traders try to estimate how financial instruments would have performed in the past had a particular mechanical trading system been employed to trade them.”   Sounds perfectly legitimate, but it isn’t.  

Backtesting is by definition performed on a finite set of data.  That could be anything, but usually it’s a set of price series.   Therefore, no matter how much or how long you backtest your forex trading strategy, the only result that you can get is that it behaves in a certain way in SOME circumstances – precisely, those that were used for the test.  It remains completely unknown how it behaves in ALL OTHER circumstances, i.e. untested – and that includes the future.  No method of backtesting, regardless of its complexity and involved precautions, can work around this.  No amount of backtesting can predict the future behavior of a forex trading strategy in real life.

So what is backtesting good for?  Well, if it is done properly and the sample is big enough, it is everything it is said to be – just if you use the word “may” instead of “will”.  A proper backtesting result is an indication of a tendency of a forex trading strategy to behave in a certain way.  Nothing more, nothing less.  It is not a guarantee.  Also, notice the word “proper”.   The many ways to get a result that does not indicate anything include using commercial backtesting software.  I’ll get into that some time.    

Still looking for the Holy Grail.

Forex mini trading is halfway between demo trading and real online forex trading.  Like demo accounts, most mini forex accounts have orders executed automatically by a computer which is way more forgiving than a human dealer executing real market orders.  Unlike a demo account, you have money at stake, which greatly enhances the trading psychology aspect of learning.  Also, forex mini trading makes it possible to practice money management techniques without risking too much capital.  

Because of automatic order execution, forex mini is mostly suitable for learning position trading and swing trading, where precise order execution is not so important.  If you develop a strategy of this type using mini forex, it usually can be applied in real market with minor modifications.  On the contrary, any type of scalping and day trading strategies that rely on immediate order execution to skim a pip here and there may work in forex mini, but are all but guaranteed to fail in real life.  The primary reasons are delays (the computer always executes promptly, while a dealer is often flooded with orders when the market moves fast) and slippage (the computer always executes at last quoted price, while such price may be simply unavailable in real market).  Spreads can be less favorable in real accounts as well.

One of the greatest features of a mini forex account is the ease of practical application of proper money management techniques.  It is our considered opinion that money and risk management are far more important than the trading strategy itself.  Indeed, it has been shown that random buy/sell decisions in combination with simple money management and position tracking strategies yield better results that any pure trading strategy.  Thus, unless you are willing to commit tens of thousands of dollars, your cash is a lot safer in a mini account.  There simply isn’t enough room for error to wipe it out with one unsuccessful trade. 

Now, why would anyone bother to open a real forex account if mini is obviously so much better?  Well, brokers know that, too, so they put a cap on the maximum amount of money in the mini account, or on the number of positions, or on position size, or maybe on all of the above.  You can make an astounding 1000% profit in forex mini trading, but it will still be only a measly $100 in absolute terms.  You’ll have to move out to the real world if you are to make any real money.  Experience with a mini account is just a great way to do that prepared.  

Books and websites teach you principles.  It is up to you to learn application.  All you need to know to begin trading can be read in an hour.  Another day of reading is not going to get you anywhere.    

Simulated trading in a forex demo account teaches you to use your forex platform.  It has little value beyond that, it’s just a computer game.  Once you know which buttons to push, you’re done.  Another day of playing computer games is not going to get you anywhere.

Trading in a real forex account teaches you to lose.  Books and games can not prepare you for the encounter with your own greed and your own fear.  Once you know that the market is smarter than you, and there are no shortcuts, you’re done.  Another day of losing is going to get you in trouble.

Time to read books again.  

This is the fastest way to make money on forex that I know.  Start today.

Second, the computer that executes your order on the demo account, doesn’t check it with the market.  It simply takes the price feed, usually from Reuters, and “executes” your order on the basis of the last available price.  In a real market, when the price is moving fast, you will most likely get a message from the dealer stating that there is no price available, or an offer that is significantly different from your order.