Transaction Fees and Backtesting (Part 2)

My last post discussed reasons to cut back from my $26/contract transaction fee assessment. Today I want to finish up by discussing further implications of transaction fees.

A back-of-the-hand calculation suggests that if I cut transaction fees by Y then I can expect an average trade of X + Y where X was the average trade with transaction fees of $26/contract.

The relationship between transaction fees and PnL is more than linear, though. If I were to repeat the bullish iron butterfly (IBF) backtest with lower transaction fees then I could expect all the winners to remain winners. Days in trade would decrease, though, and this is the wild card.

Being in the trade for a shorter period of time reduces exposure to the IBF’s biggest enemy: big market moves. Some may argue IV spikes are the biggest enemy but the two are usually coincident.

Big market moves will damage prospects most for losing trades with highest MFE. MFE often occurs just before a big market move. In these cases, the move happens and the market never looks back thereby pushing these trades to max loss. Losing trades with MFE near the profit target have the best chance to become profitable given lower transaction fees. Confused? Consider the opposite extreme: losing trades with [lowest possible] MFE equal to initial PnL won’t have a chance regardless of transaction fees because these trades never get off the ground. For the IBF, initial PnL = -8 * transaction fees/contract.

Thought about differently, lower transaction fees means the initial PnL is greater, which means fewer days of theta decay required to reach the profit target. I could sort losing trades by MFE to approximate how many trades might benefit.

I need to make sure MFE is tracked correctly in order for this to be useful. I defined MFE as the highest intratrade PnL before expiration. I questioned this metric a couple times while backtesting. Once I suggested tracking MFE after profit target was hit could be useful. Another time I suggested tracking MFE before MAE was hit. If using stop-losses then it might be useful to know MFE before the stop-loss is hit (a better MFE afterward would be meaningless with the trade already closed).

All things considered, I think the MFE methodology is satisfactory given the need described above.

With the goal of cutting transaction fees significantly by being patient with trade entry, counting trades with MAE DTE equal to initial DTE will suggest what percentage of the time this could work. These would be the trades that recorded zero MAE (although as discussed in the last post, the opportunity would still exist to be filled intraday due to usual price volatility).