Saturday, July 10, 2010

Don't Fool Yourself : Why Renko/Fixed Range Charts Cannot be Backtested Accurately with MT4 or MT5

Definitely most traders will agree with me in that renko charts (also known as fixed range charts) are one of the best tools for trading, eliminating most of the "noise" around the market and giving us a very clean picture of pivots and support and resistance levels. Renko charts "even out the blur" by displaying a new bar only when a movement of a fixed set of pips has happened. As you may see on the image shown below - an example of a renko chart - price action becomes easier to understand and overall trading becomes easier. Given the fact that fixed range charts are good for trading it then becomes obvious to ask the question : can we build and back test expert advisors for the MT4 and MT5 trading platforms that use renko/fixed range charts ? The answer to the first part of the question is yes but - very sadly - the second answer is a resounding NO. On today's post I will share with you my conclusions around this subject and why it is NOT possible to build 10 year accurate backtests of this type of charts using metatrader 4 or 5. I will also point out why results may be EXTREMELY misleading and how they may point out to a much higher profitability level than what is actually achieved.
First of all, let us talk a little bit about how we generate renko/fixed range charts on metatrader 4. We usually use one minute charts of downloaded metaquotes data and then apply a script to generate the fixed range chart we want to see. We effectively generate a history file with all the information necessary to display these new charts. Now, some people have ventured into using this data to run backtests and their results have often been pretty fantastic, however they NEGLECT to take into account some VITAL aspects of this conversion that make backtesting and especially the backtesting of scalping systems ABSOLUTELY useless.

The main problem with the backtesting of system on fixed range charts using this generated data from metaquotes one minute information is that tick data is not available. Because of this we get into a problem regarding the splitting of the bars and the actual "volume" within each one of them since the formation of fixed range bars happens "in between" one minute candles. The result is that we don't know when a new bar gets formed and the overall tick distribution becomes impossible to know. The image below shows you in a more graphical way what the problem exactly is. The end result is that a renko bar may have been formed before or after certain movements and therefore the whole movement of price and the exact formation of the fixed range bars is NOT accurate.
This effectively leads to a massive increase of the errors generated by mass interpolation and it acquires a fairly important tone when using fixed range bars in the order of 1-10 pips. This problem of generation and tick distribution can be SO large that actual simulations are absolutely unreliable to the point where backtesting results may give extremely profitable results (a few hundred dollars to billions in a few years) of a system that in reality is a simple loser. Scalpers are extremely vulnerable to this since the actual formation of the bars is not known and therefore the actual "small movements" that determine their profitability and the timing of their signals is TOTALLY different.
It is also worth understanding here that the problems with fixed range bars are FAR worse than those of a scalper within a time based chart since the actual distribution of ticks is actually known in time based charts and therefore the distribution of them between bars holds at least some similarity with reality while those of a renko chart are merely made up since no tick data to do an adequate "splitting" of the information is available. The shape of renko charts changes with one minute interpolation while this doesn't happen with time charts. However backtesting of scalpers is unreliable in either case not only due to one minute interpolation problems - which may greatly overestimate profitability - but due to the lack of execution problems and spread information.

To sum it up, even though the generation of fixed range/renko charts is possible in metatrader 4 and 5, the actual use of these charts for automated trading is not possible since the actual usage of accurate simulations to get draw down and profit targets for these systems is not possible since no tick data to do an adequate tick distribution splitting is available. For this reason if you see any system that has a modeling quality of (n/a) and the owner says the backtest was done on fixed range/renko charts you already know why this system's results are NOT reliable and why there is a GREAT chance that results are highly overestimating profitability and underestimating losses (to the point where real trading would show opposite results). Especially systems that use small renko bars and scalping techniques are bound to give astronomical results that are obviously not achieved in real trading.

Of course, renko bars are a great tool and it would be absolutely great to be able to do simulations with their data. However, until metaquotes decides to include tick data or we find a source of tick data that goes back to 2000 our chances of doing accurate simulations on this type of charts and therefore the development of systems with accurate profit and risk targets will not be possible.

If you would like to know more about automated trading and how you too can learn to code your own adaptive and likely long term profitable systems based on accurate simulations please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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