Transaction Fees and Backtesting (Part 1)

I began analyzing the data from my bullish iron butterfly (BIBF) backtest in the last post. The initial results were surprisingly poor so I want to detour and reopen the discussion about transaction fees.

Conservative assessment of transaction fees contributed to making this trade look worse than it might actually be. I also discussed this with regard to the dynamic iron butterfly. I set transaction fees to $26/contract or $208 for the whole trade. The average trade was about -$150; if I were able to do the trade for $6/contract (a nickel slippage per leg) in transaction fees then the average trade would improve to +$10. Suddenly this trade would be worth considering.

A case can be made for significantly less slippage upon exit. I spoke last time about how live trading a losing butterfly would result in significant savings: perhaps knocking transaction fees down from $104 to $30. Another example regards a profitable trade. As expiration approaches, the long legs usually decay to zero. In many cases they are worth only a nickel or dime when the profit target is hit. Rather than closing these at a cost of $26/contract, I would let them expire and save the difference.

Leaving the longs to expire also offers some end-of-cycle crash insurance were the market to make a huge move as expiration approaches. With the shorts already closed at the profit target, the longs remain risk-free. My backtesting does not take this into account. In order to see if the detail is material, I could look for big differences in maximum adverse [favorable] excursion with 2-4 DTE and the expiration PnL to get a sense of how often big moves occur in the final week.

Trade entry is another opportunity to mitigate slippage. A limit order placed at the midprice is likely to be filled within a few trading days due to the usual fluctuation in market prices. Studying MAE distribution would help to quantify this. Any trade that registers a MAE larger than -$416 is effectively a zero-slippage trade.

I am most interested to see what percentage of trades has MAE less than -$416 because these are the ones that may not fill. The risk of going unable is actually lower, though, because opportunity exists for intraday drawdowns to occur that also represent zero-slippage entries. Intraday backtesting is very time intensive so the best way to understand this is through live trading. Even if I were to use OptionVue for intraday backtesting, it only offers limited data (every 30 minutes).