From the August 01, 2012 issue of Futures Magazine • Subscribe!

Exchange emulation vs. simulation is the key to robust testing

With the advent of inexpensive high-speed computing, low-latency, high-bandwidth internet access and today’s electronic exchanges that support highly liquid and low-commission markets, there is a continuous press toward high-frequency technical trading. The desire to automate strategies, applying novel algorithms that can be tested accurately before putting real dollars at risk, is a compelling paradigm, both for the professional fund and the individual retail trader.

These developments have many individual traders asking, “How can I participate effectively in the new world of automated, high-speed, technical trading?”

The answer is they can, but they need to be careful because, in a world where profits can be made by exploiting the slightest of edges, any miscalculation in how a system will perform can create huge divergences in testing and real results. 

Trading desk technology continues to evolve and provide ever greater sophistication for the retail trader. Stock, futures, options and forex markets are now readily available with low monthly subscription, data and transaction fees. Trading tools have evolved from simple automated stock market scans to platforms that fully automate execution. Trade entry and exit decisions can be made entirely by software and executed within milliseconds. Backtesting strategies against historical data have become the standard and continue to evolve. For example, the latest TradeStation 9 product automates the in- and out-of-sample testing needed to vet a new strategy accurately (see “Software Review,” July 2011).

The next step in strategy testing has been the seamless incorporation of trade simulators. These simulators allow the trader to test manual trade execution as well as fully automated software strategies without putting actual dollars at risk. For the novice trader, the simulators support a risk-free practice of various trade entry/exit and management skills, such as using limit vs. stop orders and scale-in/scale-out execution strategies.

For the algorithmic trader looking to automate execution fully, trade simulators allow for the debugging of trade strategy software and the collection of forward, out-of-sample, test results. These are very useful and much-needed tools for the serious trader. 

However, successful trading depends on a lot more than a viable trading strategy, and simply going through the motions of order entry and liquidation does not accurately reflect real trading. If a simulator offers an inaccurate emulation of the electronic exchange, then it can lead the trader down an unprofitable path. Here, we’ll describe simulation vs. emulation and demonstrate why accurate emulation is integral to developing an accurate assessment of a complete trading approach.

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