Did you know ChartAlert ships with an end-of-day Backtester?
Go to the Trading Systems Builder / Backtester slideshows
Introduction
Neglecting brokerage charges, commissions, fees, and slippages during the backtesting of a trading strategy can distort its perceived performance and profitability.
Here are the problems and risks associated with overlooking brokerage charges and slippages in backtesting:
Overstated Profits
Ignoring brokerage charges can make a trading strategy seem more profitable than it really is. Each trade incurs transaction costs, and excluding them creates an overly optimistic view of the strategy’s performance.
Inaccurate Risk-Reward Assessment
Brokerage charges affect the risk-reward profile of a trade, and not considering them can lead to underestimating risk and overestimating reward. This distorts the assessment of the strategy’s risk management effectiveness.
Impact on Trading Frequency
Backtests ignoring transaction costs may promote excessive trading. Traders might take more trades than they would with real costs, creating unrealistic expectations of the strategy’s performance in live markets.
False Sense of Robustness
Strategies appearing robust in backtests without accounting for transaction costs may fail in live trading. Neglecting these costs gives a false sense of robustness, as transaction costs can determine a strategy’s profitability.
Inadequate Capital Allocation
Backtesting without considering transaction costs may lead to insufficient capital allocation. Traders might underestimate the capital needed for successful strategy execution, risking undercapitalization in live trading.
Underestimation of Trading Costs
Ignoring slippage underestimates overall trading costs, impacting the strategy’s profitability. Neglecting this aspect may result in suboptimal decision-making.
Suboptimal Strategy Selection
Without factoring in brokerage charges, there’s a risk of choosing suboptimal strategies. A highly profitable backtested strategy may become unviable when transaction costs are considered.
Difficulty in Strategy Evaluation
Evaluating and comparing strategies becomes challenging without considering transaction costs. Backtested superiority may not translate into live trading success when slippage is factored in.
Unrealistic Trade Execution Expectations
Transitioning from backtesting to live trading with no regard for transaction costs can lead to unrealistic expectations. Ignoring slippage may result in misjudging the ease of executing trades at specified prices.
Strategic Adjustments
Neglecting transaction costs may lead to suboptimal adjustments to make a strategy appear more profitable in backtesting. These adjustments may not work well in live trading conditions.
Unrealistic Trading Behavior
Traders may engage in impractical behavior without awareness of transaction costs, including frequent trading, unrealistic position sizing, or excessive risks based on backtest results.
Inaccurate Position Sizing
Ignoring transaction costs and slippages can lead to inaccurate position sizing calculations, exposing the trader to higher risks than anticipated.
In conclusion, it is essential to include realistic transaction costs, such as brokerage charges and slippage, when backtesting a trading strategy. This ensures a more accurate representation of the strategy’s performance and helps traders make informed decisions about its viability in real-market conditions.