Trading System #1–Backtesting Assumptions

In my last http://www.optionfanatic.com/2012/09/13/trading-system-1-introduction/ (9/13/12), I provided the rationale for a system I aim to develop.  The first step is to determine whether the SPX loses money (on average) when VIX has closed 5% or more below its 10-SMA and whether it gains at least twice as much when VIX has closed at least 5% above its 10-SMA.

Before proceeding with the backtest itself, let’s consider the assumptions.  I assumed no slippage but an $8.00 commission charge for every trade.  I assumed a starting equity of $1M and placed each trade with $100K.  My maximum number of open positions was set to 5.  The account equity must be large enough to avoid trade limitation and consequent distortion of results (do you understand why?).  Since I’m evaluating 5-day returns and placing a trade every day, I need to allow for five concomitant trades.  With a position size of $100K, the account needs to be at least $500K in size.  To handle drawdowns and still allow for all trades, I arbitrarily doubled that to $1M.  I could have used $10M.

Similarly, if looking at percent returns then you don’t want commissions to be a factor in the backtesting results.  For this reason the initial backtest does not usually include commissions.  In this case, a 1% profit per trade is $1,000.  I included the commissions of $16 (round trip) because that amounts to 1.6% of the profit, which I consider negligible.

Backtesting dates are from 1/29/1993 to 8/30/2012.  The former date corresponds to the first month VIX data were available.

I will continue in my next post with a brief discussion about statistical interpretation.