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

Exchange emulation vs. simulation is the key to robust testing

On the other hand, if-touched simulation can lead to different profit and loss results compared to actual exchange execution. “Golden strategy?” (below) shows the result of an E-mini S&P 500 futures intraday scalping strategy using an if-touched simulation of the exchange, from March through April 2012. While we might believe a trading Holy Grail has been discovered, what we have is a misleading result of if-touched backtesting. This kind of equity curve is easy to produce from a combination of a low profit-target to stop-loss ratio (in this case, approximately one-quarter) and a suitable scalping strategy. (See “Can automated scalping work for retail?” Sept. 2008).

But suppose that rather than the simple if-touched simulator, the simulator emulates the exchange, attempting to provide a more accurate fill rate from limit orders. Then, the trade strategy testing might give accurate profit-loss results and can be used as an honest testbed for developing profitable trade strategies. 

With this approach:

  1. A high-frequency trading strategy is fast-prototyped against historical data. As part of a first pass, if-touched testing can be used (perhaps with a slippage factor) as the developer is making a first approximation to gauge a trading idea.
  2. Once a successful backtest is achieved with in- and out-of-sample data, the trade strategy is moved online with a simulator that emulates the exchange. Initial testing also serves to debug the strategy implementation.
  3. Forward testing of the strategy is conducted with exchange emulation to provide realistic, out-of-sample, forward results. Emulation offers an accurate test environment to develop additional logic to take a strategy to greater profitability.

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