Truth in Backtesting (Part 3)

In http://www.optionfanatic.com/2012/11/29/truth-in-backtesting-part-2/, I described how market on close (MOC) orders will likely not be executed at the closing price.  This presents a challenge to the trade like you backtest, or “truth in backtesting” mandate.

As an alternative to using MOC orders, I might be better off manually submitting a market order just before the close.  I believe only live trading experience of placing orders x seconds before the close for different values of x can give me a true idea about resultant slippage off the closing print.  In theory, the closer to 4:00 PM ET I place an order, the smaller the closing range relative to MOC closing range, which remains constant.  I must understand the risk in trying to execute closer to 4:00 PM ET as the greater possibility of not being filled at all due to Internet blips/delays or phone tie-ups, however.  Missing a trade altogether, which in trading jargon is called an “unable,” and having to execute at the next market open could result in a much different trade price especially if the market gaps.

Application of supply/demand logic corroborates the proposition that execution at the actual closing price is uncertain.  If a large number of people were trading my system and buy (sell) orders were submitted near the close in heavy volume then the stock price would move higher (lower) with speed.  This would make execution at the closing price even less likely unless the order were submitted proportionally closer to 4:00 PM ET.  Because the increased risk of unables is very difficult, if not impossible to quantify in monetary terms, I might have to accept a minimum amount of slippage at a latest possible order submission time and incorporate that into the backtesting model.

I will introduce and discuss more truth in backtesting with my next post.